ajor hemes of the sarbanes-o ct - jackson walkerimages.jw.com/com/publications/1186.pdf · ·...

MAJOR THEMES OF THE SARBANES-OXLEY ACT

Byron F. Egan*

I. INTRODUCTION...........................................................................................343 II. PRESSURE ON AUDITORS TO DETECT CORPORATE FRAUD............346

A. GAAS.......................................................................................................346 B. Accountant Duties Under 1934 Act § 10A ..............................................348 C. SEC Enforcement Actions .......................................................................350 D. PCAOB ....................................................................................................352

III. AUDITOR INDEPENDENCE; NON-AUDIT SERVICES (SOX TITLE II) ..............................................................................................353 A. Prohibited Non-Audit Services ................................................................353 B. Audit Committee Pre-Approval of All Audit and Non-Audit Services ...359 C. Audit Partner Rotation .............................................................................364 D. Auditor Reports to Audit Committees .....................................................365 E. Prohibited Employment Relationships.....................................................367 F. Prohibited Compensation .........................................................................367

IV. CORPORATE RESPONSIBILITY (SOX TITLE III)....................................368 A. Audit Committees ....................................................................................368

1. Audit Committee Member Independence...........................................369 2. Responsibilities Relating to Registered Accounting Firms ................371 3. Procedures for Handling “Whistleblower” Complaints .....................372 4. Authority to Engage Advisors ............................................................373 5. Funding...............................................................................................373 6. Trading Markets Affected ..................................................................373 7. Issuers and Securities Affected...........................................................374 8. Small Businesses ................................................................................374 9. Investment Companies .......................................................................374 10. Determining Compliance with Standards...........................................374 11. Opportunity to Cure Defects...............................................................375 12. Audit Committee Charters..................................................................375 13. Disclosure Changes Regarding Audit Committees ............................375

B. CEO/CFO Certifications ..........................................................................376 1. SOX § 906 Certification .....................................................................376 2. SOX § 302 Certification .....................................................................377 3. Enforcement Actions ..........................................................................380

C. CEO/CFO Reimbursement to Issuer ........................................................380

* Copyright© 2009 by Byron F. Egan. All rights reserved. Byron F. Egan is a partner of Jackson Walker L.L.P. in Dallas, Texas. Mr. Egan is Vice-Chair of the ABA Business Law Section’s Negotiated Acquisitions Committee and former Co-Chair of its Asset Acquisition Agreement Task Force, which published the ABA Model Asset Purchase Agreement with Commentary in 2001. He is also a member of the American Law Institute. Mr. Egan is a former Chairman of the Texas Business Law Foundation and is also former Chairman of the Business Law Section of the State Bar of Texas and of that Section’s Corporation Law Committee. The author wishes to acknowledge the contributions of the following in preparation of this article: C. Alex Frutos and David P. Hamm, Jr. of Jackson Walker L.L.P. in Dallas, Texas.

340 TEXAS JOURNAL OF BUSINESS LAW [VOL. 42:3

D. D&O Bars.................................................................................................381 E. Insider Trading Freeze During Plan Blackout..........................................381

1. Regulation BTR..................................................................................382 2. Persons Subject to Trading Prohibition ..............................................382 3. Securities Subject to Trading Prohibition...........................................383 4. Transactions Subject to Trading Prohibition ......................................383

a. Acquired in Connection with Service or Employment as a Director or Executive Officer .......................................................383

b. Service or Employment Presumption ...........................................384 c. Transitional Situations..................................................................385 d. Exempt Transactions ....................................................................385

5. Blackout Period ..................................................................................387 a. Individual Account Plan ...............................................................387 b. Blackout Period ............................................................................387 c. Determining Participants and Beneficiaries .................................387 d. Exceptions to Definition of Blackout Period................................388

6. Remedies ............................................................................................389 7. Notice of Blackout Period ..................................................................390

V. ENHANCED FINANCIAL DISCLOSURES; PROHIBITION ON INSIDER LOANS (SOX TITLE IV) ..............................................................390 A. Off-Balance Sheet Transactions; Use of Non-GAAP Financial

Measures ..................................................................................................390 1. MD&A Disclosures ............................................................................391 2. Conditions for Use of Non-GAAP Financial Measures:

Regulation G.......................................................................................393 B. Form 8-K Filings of Earnings Releases ...................................................398 C. Prohibition on Loans to Directors or Officers..........................................401 D. Accelerated § 16(a) Reporting .................................................................404

1. Two Business Days to File Form 4 ....................................................404 2. Website Posting ..................................................................................405 3. Procedures for Filing § 16(a) Reports on EDGAR.............................407

a. EDGAR Access Codes ................................................................407 b. Use of a Filing Service .................................................................408 c. Filing By or On Behalf of Insider.................................................408 d. Additional Points to Consider.......................................................409

E. Internal Controls.......................................................................................409 F. Codes of Ethics ........................................................................................415 G. Audit Committee Financial Experts.........................................................417 H. Systematic SEC Review of 1934 Act Filings...........................................422 I. Accelerated Disclosure in Plain English ..................................................423

VI. CORPORATE AND CRIMINAL FRAUD ACCOUNTABILITY (SOX TITLE VIII).....................................................................................................424 A. Records Retention ....................................................................................424 B. Non-dischargeable Fraud Judgments .......................................................425 C. Extension of Statute of Limitation for Securities Fraud Claims ..............425 D. Sentencing Guidelines..............................................................................426 E. Whistleblower Protection.........................................................................426

2008] MAJOR THEMES OF SARBANES-OXLEY 341

F. Enhanced Fraud Penalties ........................................................................427 VII. MISLEADING STATEMENTS TO AUDITORS..........................................427

A. SOX § 303 Requirements.........................................................................427 B. Enforcement .............................................................................................429 C. False Confirmations .................................................................................435 D. Internal Investigations..............................................................................436 E. Relationship of SOX § 303 Requirements to 1934 Act § 10A ................437 F. Foreign Private Issuers .............................................................................437

VIII. ENHANCED ATTORNEY RESPONSIBILITIES UNDER SOX.................438 A. SOX § 307................................................................................................438 B. Relationship to State Disciplinary Rules..................................................438 C. Attorneys Covered ...................................................................................439 D. Who is the Client?....................................................................................440 E. What Evidence Triggers Reporting Duty? ...............................................440 F. Duty to Report Evidence of a Material Violation ....................................442 G. Alternative Reporting Procedures For An Issuer That Has Established

A QLCC ...................................................................................................445 H. Issuer Confidences ...................................................................................445 I. Responsibilities of Supervisory Attorneys ...............................................446 J. Responsibilities of a Subordinate Attorney..............................................447 K. Sanctions and Discipline ..........................................................................447 L. No SOX § 307 Private Right of Action....................................................447 M. Enron Civil Liability Fallout ....................................................................448 N. Attorney-Client/Work Product Privilege .................................................450 O. Differences From Proposed Rules............................................................450

IX. ATTORNEY LETTERS TO AUDITORS......................................................452 A. SFAS 5 .....................................................................................................452 B. SAS 12 .....................................................................................................452 C. ABA Statement ........................................................................................454 D. Discoverability of Audit Response Letters ..............................................460

X. SELECTED RESPONSE LETTER ISSUES..................................................466 A. Is the ABA Statement Superseded by SOX § 303?..................................466 B. The Company Dilemma ...........................................................................466 C. Law Firm Policies ....................................................................................468 D. Estimates of Loss .....................................................................................468 E. Requests Beyond Scope of ABA Statement ............................................469 F. Requests for Updates or Informal Discussions ........................................471 G. Information as to Specific Cases..............................................................472 H. Inside Counsel Special Issues ..................................................................472 I. Triangle ....................................................................................................474 J. Gain Contingencies ..................................................................................474

XI. LIMITATION OF LIABILITY PROVISIONS IN AUDITOR ENGAGEMENT LETTERS ...........................................................................476

XII. EFFECT OF SOX ON FOREIGN COMPANIES ..........................................479 A. Which Foreign Companies Are Subject to SOX?....................................479 B. What Differences Are There in the Application of SOX Provisions to

Foreign Private Issuers? ...........................................................................479


1. Public Company Accounting Oversight Board ..................................479 2. Auditor Independence; Non-Audit Services.......................................480

C. Corporate Responsibility..........................................................................480 1. Audit Committee Independence Rules ...............................................480

a. Allowing Non-Management Employee to Serve..........................480 b. Allowing Controlling Shareholder to Serve .................................480 c. Allowing Government Representative to Serve ...........................480 d. No Independent Audit Committee Required if Board of

Auditors ........................................................................................481 e. Audit Committee Financial Experts .............................................481

2. CEO/CFO Certifications under §§ 302 and 906.................................482 3. Misleading Statements to Auditors.....................................................482 4. CEO/CFO Reimbursement .................................................................482 5. Insider Trading Freeze During Plan Blackout ....................................482 6. Enhanced Attorney Responsibilities...................................................483

D. Enhanced Financial Disclosures; Prohibition on Insider Loans...............485 1. Off-Balance Sheet Transactions; Use of Non-GAAP Financial

Measures.............................................................................................485 2. Conditions for Use of Non-GAAP Financial Measures:

Regulation G.......................................................................................486 3. Internal Controls .................................................................................488 4. Prohibition on Loans to Directors and Officers..................................489 5. Accelerated § 16(a) Reporting............................................................491 6. Code of Ethics ....................................................................................491 7. Systematic Review of 1934 Act Filings .............................................491 8. Accelerated Disclosure in Plain English ............................................491 9. Accelerated Filing Deadlines..............................................................491 10. Enhanced MD&A Disclosure.............................................................491 11. Termination of SEC Filing Obligations..............................................492

XIII. EFFECT OF SOX ON PRIVATE COMPANIES AND BUSINESS COMBINATIONS ..........................................................................................492

XIV. CONCLUSION ...............................................................................................497 EXHIBIT A: ATTORNEY-CLIENT PRIVILEGE AND THE WORK

PRODUCT DOCTRINE IN THE CORPORATE CONTEXT.......................498 A. Introduction ..............................................................................................498 B. Attorney-Client Privilege .........................................................................498

1. Overview ............................................................................................498 2. Derivative Actions..............................................................................499 3. Legal Advice Purpose.........................................................................501 4. Internal Investigations ........................................................................504 5. Generally Unprivileged Items ............................................................507 6. Waiver ................................................................................................507 7. No Waiver Where Common Interest ..................................................508 8. Issue Injection.....................................................................................509 9. Scope of Waiver .................................................................................511 10. Federal Rule of Evidence 502 Limiting Waiver of Privileges ...........516 11. Exceptions to the Privilege .................................................................517


C. Work Product Doctrine ............................................................................518 D. Legal Fee Audits ......................................................................................522 E. Mergers and Acquisitions ........................................................................523

EXHIBIT B: FORM OF OUTSIDE LAW FIRM RESPONSE LETTER .................527 ANNEX A: MISCELLANEOUS MATTERS ...........................................................530 ANNEX B: DESCRIPTION OF LOSS CONTINGENCIES ....................................532

I. INTRODUCTION

On July 30, 2002 President Bush signed the Sarbanes-Oxley Act of 2002 (H.R. 3763) (“SOX”).1 This was the “tough new corporate fraud bill” trumpeted by the politicians and in the media as a response to the corporate scandals of 2001–02 and as a means to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws. Among other things, SOX amended the Securities Exchange Act of 1934 (the “1934 Act”) and the Securities Act of 1933 (the “1933 Act”). Although SOX does have some specific provisions, and generally establishes some important public policy changes, it has been implemented in large part through rules adopted and to be adopted by the Securities and Exchange Commission (“SEC”) and the Public Company Accounting Oversight Board (“PCAOB”), which have impacted auditing standards and have increased scrutiny on auditors’ independence and procedures to verify company financial statement positions and representations. Further, while SOX is by its terms generally applicable only to public companies,2 its principles are being applied by the marketplace to privately held companies3

1 See Byron F. Egan, The Sarbanes-Oxley Act and Its Expanding Reach, 40 TEX. J. BUS. L. 305 (Winter 2005);

Byron F. Egan, Communicating with Auditors After the Sarbanes-Oxley Act, 41 TEX. J. BUS. L. 131 (Fall 2005). 2 SOX is generally applicable to all companies required to file reports with the SEC under the 1934 Act

(“reporting companies”) or that have a registration statement on file with the SEC under the 1933 Act, in each case regardless of size (collectively, “public companies” or “issuers”). Some of the SOX provisions apply only to companies listed on a national securities exchange (“listed companies”), such as the New York Stock Exchange (“NYSE”) or the NASDAQ Stock Market (“NASDAQ”) (the national securities exchanges and NASDAQ are referred to collectively as “SROs”), but not to companies traded on the NASD OTC Bulletin Board or quoted in the Pink Sheets or the Yellow Sheets. See Standards Relating to Listed Company Audit Committees, Securities Act Release No. 8220, Exchange Act Release No. 47,654, 79 SEC Docket 2876 (Apr. 9, 2003), available at http://www.sec.gov/rules/final/33-8220.htm. Small business issuers that file reports on Form 10-QSB and Form 10-KSB are subject to SOX generally in the same ways as larger companies although some specifics vary (references herein to Forms 10-Q and 10-K include Forms 10-QSB and 10-KSB). “Small business issuer” is defined in 1934 Act Rule 0-10(a) as an issuer (other than an investment company) that had total assets of $5 million or less on the last day of its most recent fiscal year, except that for the purposes of determining eligibility to use Forms 10-KSB and 10-QSB that term is defined in 1934 Act Rule as a United States (“U.S.”) or Canadian issuer with neither annual revenues nor “public float” (aggregate market value of its outstanding voting and non-voting common equity held by non-affiliates) of $25 million or more. SEC Registration and Reporting General, 17 C.F.R. § 240.12b-2 (2006). Some of the rules adopted under SOX apply more quickly to larger companies that are defined as “accelerated filers” under 1934 Act Rule 12b-2 (generally issuers with a public common equity float of $75 million or more as of the last business day of the issuer’s most recently completed second fiscal quarter that have been reporting companies for at least 12 months). Id. SOX and the SEC’s rules thereunder are applicable in many, but not all, respects to (i) investment companies registered under the Investment Company Act of 1940 (the “1940 Act”) and (ii) public companies domiciled outside of the United States of America (the “U.S.”) (“foreign companies”). Many of the SEC rules promulgated under SOX’s


and nonprofit entities.4

Following the enactment of SOX and the adoption of rules thereunder, the role of independent auditors in detecting financial statement fraud within public companies has received enhanced scrutiny. In turn, companies are expected both to implement controls for dealing with alleged fraud internally and to provide their auditors with detailed information on a wide range of corporate issues. Companies involve legal counsel, both inside and outside, for a wide variety of tasks, from conducting investigations of alleged fraud to dealing with

directives provide limited relief from some SOX provisions for the “foreign private issuer,” which is defined in 1933 Act Rule 405 and 1934 Act Rule 3b-4(c) as a private corporation or other organization incorporated outside of the U.S., as long as:

(i) more than 50% of the issuer’s outstanding voting securities are not directly or indirectly held of record by U.S. residents;

(ii) the majority of the executive officers or directors are not U.S. citizens or residents;

(iii) more than 50% of the issuer’s assets are not located in the U.S.; and

(iv) the issuer’s business is not administered principally in the U.S. SEC Rules and Regulations Under the Securities Exchange Act of 1934, 17 C.F.R. § 240.3b-4(c) (2008). Companies that file periodic reports with the SEC solely to comply with covenants under debt instruments, to facilitate sales of securities under Rule 144 or for other corporate purposes (“voluntary filers”), rather than pursuant to statutory or regulatory requirements to make such filings, are not issuers and generally are not required to comply with most of the corporate governance provisions of SOX. The SEC’s rules and forms implementing SOX that require disclosure in periodic reports filed with the SEC apply to voluntary filers by virtue of the fact that voluntary filers are contractually required to file periodic reports in the form prescribed by the rules and regulations of the SEC. The SEC appears to be making a distinction in its rules between governance requirements under the Act (which tend to apply only to statutory “issuers”) and disclosure requirements (which tend to apply to all companies filing reports under the 1934 Act). While SOX is generally applicable only to public companies, there are three important exceptions: (i) SOX §§ 802 and 1102 make it a crime for any person to alter, destroy, mutilate or conceal a record or document so as to (x) impede, obstruct or influence an investigation or (y) impair the object’s integrity or availability for use in an official proceeding, 18 U.S.C. § 1519 (Supp. 2007); 18 U.S.C. § 1512 (2000 & Supp. 2007); (ii) SOX § 1107 makes it a crime to knowingly, with the intent to retaliate, take any action harmful to a person for providing to a law enforcement officer truthful information relating to the commission of any federal offense, 18 U.S.C. § 1513 (2000 & Supp. 2007); and (iii) SOX § 904 raises the criminal monetary penalties for violation of the reporting and disclosure requirements of the Employee Retirement Income Security Act of 1974 (“ERISA”), 29 U.S.C. § 1131 (Supp. 2007). These three provisions are applicable to private and nonprofit entities as well as public companies.

3 Private companies that contemplate going public, seeking financing from investors whose exit strategy is a public offering or being acquired by a public company may find it advantageous or necessary to conduct their affairs as if they were subject to SOX. See Mark Peters, Jin-Kyu Koh & Jeffrey Belisle, Private Companies Toe the SOX Line, MERGERS & ACQUISITIONS (Oct. 2005 at 34–36); Joseph Kubarek, Sarbanes-Oxley Raises the Bar for Private Companies, NACD-DIRECTORS MONTHLY (June 2004 at 19–20); Peter H. Ehrenberg & Anthony O. Pergola, Why Private Companies Should Not Ignore the Sarbanes-Oxley Act, 6 No. 7 WALLSTREETLAWYER.COM: SEC. ELEC. AGE 12, at 12–13 (2002).

4 See Sheri Qualters, Nonprofits Scramble Under New Scrutiny, THE NAT’L L. J. (Sept. 3, 2007); The Sarbanes-Oxley Act and Implications for Nonprofit Organizations, BoardSource, (2003), available at http://www.boardsource.org/clientfiles/sarbanes-oxley.pdf; Richard Merli, Sarbanes-Oxley Rules Seeping Into Not-for-Profit Hospitals, KPMG INSIDER (Dec. 15, 2004), available at http://www.kpmginsights.com/display_analysis_print_nobuttons.asp?content_id=512552.


employee issues (including whistleblower complaints) and advising directors on their duties in connection with corporate transactions. Auditors are increasingly asking for information regarding these often privileged communications to supplement their reliance on management representations. Making such privileged information available to auditors, however, subjects companies to the risk of loss of attorney client and work product privileges, which can provide a road-map to success for adversaries in civil litigation.

Further, in providing such information to auditors, the provider must comply with the requirements of Section 303 of SOX (“SOX § 303”) and expanded Rule 13b2-25 under the 1934 Act adopted pursuant to SOX § 303 (collectively, the “SOX § 303 Requirements”). The SOX § 303 Requirements specifically prohibit officers and directors, and “persons acting under [their] direction,” from coercing, manipulating, misleading, or fraudulently influencing (collectively referred to herein as “improperly influencing”) an auditor “engaged in the performance of an audit” of the issuer’s financial statements when the officer, director, or other person “knew or should have known” that the action, if successful, could result in rendering the issuer’s financial statements filed with the SEC materially misleading.6 Since attorneys and other mergers and acquisitions (“M&A”) professionals representing a corporation are usually engaged by, and are acting at the direction of, its directors or officers, they are subject to the SOX § 303 Requirements.

In addition, the requirements of SOX § 307 are specifically applicable to attorneys. The SEC rules under SOX § 307 generally provide that, in the event that an attorney has “credible evidence based upon which it would be unreasonable, under the circumstances, for a prudent and competent attorney not to conclude that it is reasonably likely that a material violation [of any U.S. law or fiduciary duty] has occurred, is ongoing, or is about to occur,” the attorney has a duty to seek to remedy the problem by “reporting up the ladder” within the issuer to the issuer’s chief legal officer, or to both the chief legal officer and the chief executive officer, or if those executives do not respond appropriately, to the issuer’s board of directors or an appropriate committee thereof.7

The SOX § 303 Requirements should influence an attorney in communicating with accountants, and reinforce the importance of providing meaningful information to auditors and clients. The SOX § 303 Requirements, however, should not be viewed as repudiating or supplanting the grand compromise or treaty reached in 1976 between the lawyers and the accountants that is reflected in the ABA Statement of Policy regarding Lawyers’ Responses to Auditors’ Requests for Information (the “ABA Statement”),8 which was intended to facilitate

5 Improper Influence on Conduct of Audits, Exchange Act Release No. 47,890, Investment Company Act Release

No. 26,050, 80 SEC Docket 770 (May 20, 2003), available at http://www.sec.gov/rules/final/34-47890.htm. See infra notes 414–17 and related text.

6 Cf. Id. See infra notes 458–516 and related text. 7 Implementation of Standards of Professional Conduct for Attorneys, Securities Act Release No. 8185,

Exchange Act Release No. 47,276, Investment Company Act Release No. 25,919, 79 SEC Docket 1351 (Jan. 29, 2003), available at http://www.sec.gov/rules/final/33-8185.htm.

8 See Statement of Policy Adopted by American Bar Association Regarding Responsibilities and Liabilities of Lawyers in Advising with Respect to the Compliance by Clients with Laws Administered by the Securities and Exchange Commission, 31 BUS. LAW. 543 (1976).


lawyers’ provision of information to auditors regarding client loss contingencies in connection with the preparation and examination of client financial statements, while minimizing the risk of loss of attorney-client privilege in the process.9 Auditors rely upon the letters provided by their clients’ counsel regarding loss contingencies (“Response Letters”) as they examine and report upon client financial statements. This gives the Response Letters a significant role in financial disclosure processes. Malpractice and other claims against attorneys can result from Response Letters and other statements to auditors regarding loss contingencies, particularly when a prediction is made regarding the likelihood of an unfavorable outcome or the amount or range of loss in the event of an unfavorable outcome. A lawyer who prepares a Response Letter in accordance with the ABA Statement, however, should not be considered to have misled or otherwise improperly influenced an auditor as the letter typically states that it was prepared in accordance with the ABA Statement and is prepared in response to a request letter that also should conform to the ABA Statement.

While not denying the right of lawyers to rely on the ABA Statement in actions taken in conformity with the ABA Statement, SEC rulemaking and enforcement actions post-SOX attempt to place lawyers in the role of “gatekeepers” or “sentries of the marketplace” whose responsibilities include “ensuring that our markets are clean.”10 These SEC actions do, however, affect the role of the lawyer in dealing with clients, auditors, M&A professionals and others.11

II. PRESSURE ON AUDITORS TO DETECT CORPORATE FRAUD

A. GAAS

Generally acceptable auditing standards (“GAAS”) recognize that auditors have particular responsibilities with respect to the discovery of corporate fraud during an audit. The auditor has a responsibility to plan and to perform financial statement audits in order to obtain “reasonable assurance” about whether the financial statements are free of material misstatement, whether caused by error or fraud.12

9 See infra Exhibit A Attorney Client Privilege and Work Product Doctrine in the Corporate Context. 10 Stephen M. Cutler, Director, SEC Div. of Enforcement, The Themes of Sarbanes-Oxley as Reflected in the

Commission’s Enforcement Program, Speech at the UCLA School of Law (Sept. 20, 2004) (making the point that SOX attempts to protect investors from a repeat of the scandals that led to its enactment by regulating “[t]he sentries of the marketplace: the auditors who sign off on companies’ financial data; the lawyers who advise companies on disclosure standards and other securities law requirements; the research analysts who warn investors away from unsound companies; and the boards of directors responsible for oversight of company management”), available at http://www.sec.gov/news/speech/spch092004smc.htm. Speeches by SEC members or staff are the expressions of the speakers themselves, and are not to be construed as representations of the Commission itself.

11 See infra notes 414–17, 458–516 and related text. 12 CODIFICATION OF AUDITING STANDARDS AND PROCEDURES, Statement on Auditing Standards No. 1 (Am.

Inst. of Certified Pub. Accountants). See also RESPONSIBILITIES AND FUNCTIONS OF THE INDEPENDENT AUDITOR, Statement on Auditing Standards No. 1, § 110.02 (Am. Inst. of Certified Pub. Accountants), available at http://www.aicpa.org/download/members/div/auditstd/AU-00110.PDF, and Interagency Advisory on the Unsafe and Unsound Use of Limitation of Liability Provisions in External Audit Engagement Letters, 71 Fed. Reg. 6847, at 6849 (Feb. 9, 2006), available at http://a257.g.akamaitech.net/7/257/2422/01jan20061800/edocket.access.gpo.gov/2006/pdf/06-1189.pdf, wherein five federal agencies supervising financial institutions stated that they “believe that including an


Accounting Standards Board Statement on Auditing Standards (“SAS”) No. 99 (“SAS 99”) establishes guidance to help auditors to fulfill that responsibility with respect to fraud.13 In the allocation of responsibilities between auditors and their clients, “it is management’s responsibility to design and implement programs and controls to prevent, deter, and detect fraud.”14 In connection with its audit of financial statements in accordance with GAAS, the auditor’s “interest” is in obtaining evidential matter regarding intentional acts that “result in a material misstatement of the financial statements.”15

Thus, the auditor, in exercising the required professional skepticism when planning and performing the audit, is to consider whether the presence of certain “risk factors” indicate the possible presence of fraud and, if risks of fraudulent, material misstatement are identified, consider the impact of this finding on the audit report and whether reportable conditions relating to the company’s internal controls exist and should be communicated to the company or its audit committee.16 An auditor’s obligations to gather evidential matter to satisfy itself regarding the presence of fraud includes making inquiries “about the existence or suspicion of fraud” to any appropriate personnel within the company, and SAS 99 suggests that the auditor “may wish to direct these inquiries” to the company’s inside legal counsel.17

indemnification or limitation of liability provision for the client’s knowing misrepresentations, willful misconduct, or fraudulent behavior in an Audit engagement letter may not be viewed as consistent with the auditor’s duty and obligation to comply with auditing standards.”

13 CONSIDERATION OF FRAUD IN A FINANCIAL STATEMENT AUDIT, Statement on Auditing Standards No. 99, § 316 (Am. Inst. of Certified Pub. Accountants), available at http://www.aicpa.org/download/members/div/auditstd/AU-00316.PDF.

14 Id. SAS No. 99 superseded SAS No. 82, also entitled, Consideration of Fraud in a Financial Statement Audit. Id. SAS 82 provided that “[t]he auditor has a responsibility to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.” CONSIDERATION OF FRAUD IN A

FINANCIAL STATEMENT AUDIT, Statement on Auditing Standards No. 82, § 316 (Am. Inst. of Certified Pub. Accountants). This standard, however, expressly disavowed any per se obligation on auditors to uncover all instances of corporate fraud; indeed, SAS 82 recognized that a properly performed and executed audit may fail to detect fraud. Id. As it explained:

An auditor cannot obtain absolute assurance that material misstatements in the financial statements will be detected. Because of (a) the concealment aspects of fraudulent activity, including the fact that fraud often involves collusion or falsified documentation, and (b) the need to apply professional judgment in the identification and evaluation of fraud risk factors and other conditions, even a properly planned and performed audit may not detect a material misstatement resulting from fraud.

Id. 15 CONSIDERATION OF FRAUD IN A FINANCIAL STATEMENT AUDIT, Statement on Auditing Standards No. 99,

§ 316 (Am. Inst. of Certified Pub. Accountants), available at http://www.aicpa.org/download/members/div/auditstd/AU-00316.PDF.

16 Id. at §§ 316.05, 316.12, 316.31, 316.80. 17 Id. at §§ 316.24–.25. Other guidance found in GAAS suggests that an auditor may wish to obtain evidential

matter through company counsel. In regard to an auditor’s obligations regarding loss contingencies for litigation, claims and assessments pursuant to FAS 5, GAAS states that the “opinion of legal counsel on specific tax issues that he is asked to address and to which he has devoted substantive attention . . . can be useful to the auditor in forming his own opinion.” See EVIDENTIAL MATTER: AUDITING INTERPRETATIONS OF SECTION 326, Statement on Auditing Standards No. 31, § 9326.19 (Am. Inst. of Certified Pub. Accountants) (warning further that “it is not appropriate for the auditor to rely solely on such legal opinion” in conducting the audit regarding these issues).


B. Accountant Duties Under 1934 Act § 10A

Section 10A of the 1934 Act,18 which was added by the Private Securities Litigation

18 15 U.S.C. § 78j-1 (2000 & Supp. 2002). The relevant portion of § 10A of the 1934 Act was modeled after

SAS 53, the predecessor to SAS 82, and provides as follows:

Sec. 10A. Audit requirements (Sec. 78j–1)

(a) In general. Each audit required pursuant to this title of the financial statements of an issuer by a registered public accounting firm shall include, in accordance with generally accepted auditing standards, as may be modified or supplemented from time to time by the Commission—

(1) procedures designed to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts;

(2) procedures designed to identify related party transactions that are material to the financial statements or otherwise require disclosure therein; and

(3) an evaluation of whether there is substantial doubt about the ability of the issuer to continue as a going concern during the ensuing fiscal year.

(b) Required response to audit discoveries.

(1) Investigation and report to management. If, in the course of conducting an audit pursuant to this title to which subsection (a) applies, the registered public accounting firm detects or otherwise becomes aware of information indicating that an illegal act (whether or not perceived to have a material effect on the financial statements of the issuer) has or may have occurred, the firm shall, in accordance with generally accepted auditing standards, as may be modified or supplemented from time to time by the Commission—

(A) (i)determine whether it is likely that an illegal act has occurred; and

(ii) if so, determine and consider the possible effect of the illegal act on the financial statements of the issuer, including any contingent monetary effects, such as fines, penalties, and damages; and

(B) as soon as practicable, inform the appropriate level of the management of the issuer and assure that the audit committee of the issuer, or the board of directors of the issuer in the absence of such a committee, is adequately informed with respect to illegal acts that have been detected or have otherwise come to the attention of such firm in the course of the audit, unless the illegal act is clearly inconsequential.

(2) Response to failure to take remedial action. If, after determining that the audit committee of the board of directors of the issuer, or the board of directors of the issuer in the absence of an audit committee, is adequately informed with respect to illegal acts that have been detected or have otherwise come to the attention of the firm in the course of the audit of such accountant, the registered public accounting firm concludes that—

(A) the illegal act has a material effect on the financial statements of the issuer;

(B) the senior management has not taken, and the board of directors has not caused senior management to take, timely and appropriate remedial actions with respect to the illegal act; and

(C) the failure to take remedial action is reasonably expected to warrant departure from a standard report of the auditor, when made, or warrant resignation from the audit engagement;

the registered public accounting firm shall, as soon as practicable, directly report its conclusions to the board of directors.


Reform Act of 1995 (“PSLRA”),19 created additional reporting obligations for auditors with regard to fraud that had not existed prior to that time. Like GAAS, § 10A requires auditors to employ procedures, in accordance with GAAS, designed to provide “reasonable assurance of detecting illegal acts” that would have a direct and material effect on the financial statements.20 In addition, however, § 10A requires auditors to report evidence of fraud up the corporate ladder to management and to the audit committee under certain circumstances.21 Section 10A further requires that the auditor report not only up, but out to the SEC if—after investigation of evidence of an illegal act uncovered during an audit—the auditor determines that: (1) the audit committee or board is adequately informed of the illegal act, (2) the illegal act has a material effect on the financial statements, (3) the illegal act has not been appropriately remediated, and

(3) Notice to Commission; response to failure to notify. An issuer whose board of directors receives a report under paragraph (2) shall inform the Commission by notice not later than 1 business day after the receipt of such report and shall furnish the registered public accounting firm making such report with a copy of the notice furnished to the Commission. If the registered public accounting firm fails to receive a copy of the notice before the expiration of the required 1-business-day period, the registered public accounting firm shall—

(A) resign from the engagement; or

(B) furnish to the Commission a copy of its report (or the documentation of any oral report given) not later than 1 business day following such failure to receive notice.

(4) Report after resignation. If a registered public accounting firm resigns from an engagement under paragraph (3)(A), the firm shall, not later than 1 business day following the failure by the issuer to notify the Commission under paragraph (3), furnish to the Commission a copy of the report of the firm (or the documentation of any oral report given).

(c) Auditor liability limitation. No registered public accounting firm shall be liable in a private action for any finding, conclusion, or statement expressed in a report made pursuant to paragraph (3) or (4) of subsection (b), including any rule promulgated pursuant thereto.

(d) Civil penalties in cease-and-desist proceedings. If the Commission finds, after notice and opportunity for hearing in a proceeding instituted pursuant to section 21C, that a registered public accounting firm has willfully violated paragraph (3) or (4) of subsection (b), the Commission may, in addition to entering an order under section 21C, impose a civil penalty against the registered public accounting firm and any other person that the Commission finds was a cause of such violation. The determination to impose a civil penalty and the amount of the penalty shall be governed by the standards set forth in section 21B.

(e) Preservation of existing authority. Except as provided in subsection (d), nothing in this section shall be held to limit or otherwise affect the authority of the Commission under this title.

(f) Definitions. As used in this section, the term “illegal act” means an act or omission that violates any law, or any rule or regulation having the force of law. As used in this section, the term “issuer” means an issuer (as defined in section 3), the securities of which are registered under section 12, or that is required to file reports pursuant to section 15(d), or that files or has filed a registration statement that has not yet become effective under the Securities Act of 1933 (15 U.S.C. 77a et seq.), and that it has not withdrawn.

Id. 19 Section 10A is the part of the 1934 Act entitled “Audit Requirements” and predates SOX; Section 10A was

added to the 1934 Act on December 22, 1995 as part of the PSLRA: Title III—Auditor Disclosure of Corporate Fraud. When Congress passed SOX, it tacked on the SOX requirements to the preexisting illegal act requirements from the PSLRA.

20 15 U.S.C. § 78j-1 (2000 & Supp. 2002). 21 Id.


(4) as a result, the auditor will be required to issue a qualified audit opinion or resign.22 The creation of the “illegal act” requirement of § 10A exposed auditors to potential administrative proceedings based not only on alleged deficiencies in their audits or reviews of financial statements, but also on allegations that they have taken insufficient steps to satisfy these reporting requirements.

C. SEC Enforcement Actions

Under SEC Rule 102(e)(1)(ii), the SEC may sanction accountants for “improper professional conduct.”23 Administrative and enforcement actions filed in recent years reflect enhanced scrutiny of the work of auditors who failed to catch fraud by their clients or to take sufficient steps to satisfy § 10A.24 When Stephen Cutler was Director of the SEC Division of

22 Id. Section 10A requires (in plain English) that if an auditor becomes aware of anything indicating that an

illegal act has or may have occurred at one of her public clients, her firm must: inform the appropriate level of management and the audit committee of the issue; conclude whether there has been an illegal act that has a material effect on the financials; conclude whether the company has taken timely and appropriate remedial action; and report the client to the SEC if the client fails to take timely and appropriate remedial action. Id.

23 Securities and Exchange Commission Rules, 17 C.F.R. § 201.102 (2008). SEC Rule 102(e)(1)(iv) defines improper professional conduct as follows:

(A) Intentional or knowing conduct, including reckless conduct, that results in a violation of applicable professional standards; or

(B) Either of the following two types of negligent conduct:

(1) A single instance of highly unreasonable conduct that results in a violation of applicable professional standards in circumstances in which an accountant knows, or should know, that heightened scrutiny is warranted.

(2) Repeated instances of unreasonable conduct, each resulting in a violation of applicable professional standards, that indicate a lack of competence to practice before the Commission.

Id. SEC Rule 102(e)(1)(iv) History: Section (iv) was added to the Rule in 1998 to address the D.C. Circuit’s concerns—as expressed in Checkosky v. S.E.C., 23 F.3d 452 (D.C. Cir. 1994) (hereinafter Checkosky I) and Checkosky v. S.E.C., 139 F.3d 221 (D.C. Cir. 1998) (hereinafter Checkosky II)—about the lack of clarity in the term “improper professional conduct.” Marrie v. S.E.C., 374 F.3d 1196, 1198 (D.C. Cir. 2004) (stating “we begin with the observation that in the amended Rule 102(e), the Commission has cured the defects identified in Checkosky I and II”).

24 See Deloitte & Touche LLP, Exchange Act Release No. 51,607, 85 SEC Docket 849 (Apr. 26, 2005), available at http://www.sec.gov/litigation/admin/34-51607.pdf (adjudicating action against Deloitte and personnel in connection with audit of the financial statements of Just for Feet, Inc. which: (i) improperly recognized as income the value of advertising support from suppliers rather than as a reduction of merchandise cost which GAAP required and sometimes before all conditions precedent to its entitlement to the support had been satisfied and (ii) failed to provide adequate reserves for obsolete inventory; although Just for Feet was regarded as a high risk client which was run by an autocrat, interpreted accounting standards aggressively and had presented issues in prior audits, the SEC found Deloitte’s audit processes did not insist on proper vendor confirmations (some of which were found to be ambiguous or incomplete and some of which contained vendor misstatements); Deloitte was fined $375,000 and the individuals were prohibited from practicing before the SEC); Deloitte & Touche LLP, Exchange Act Release No. 51,606, 85 SEC Docket 841 (Apr. 26, 2005), available at http://www.sec.gov/litigation/admin/34-51606.pdf (adjudicating action against Deloitte for failure to detect a massive fraud in audits of Adelphia Communications Corporation although Adelphia was regarded a very high risk because of management dominated by Rigas family without compensating controls, management tendency to interpret accounting standards aggressively and frequent disputes with auditors, transactions with unaudited affiliated parties (some of which posed form over substance questions) and high capital


Enforcement, he called auditors “the sentries of the marketplace,” and said that the SEC was focusing on auditing firm responsibility for audits in the hope that “accounting firms will take an even greater role in ensuring that individual auditors are properly discharging their special

requirements and debt levels (some obligations were classified as guarantees even though documents showed Adelphia was jointly and severally liable with related party borrowers and the financial condition of some borrowers made it probable under FAS 5 that Adelphia would have to pay the debt), Deloitte failed to detect Adelphia’s fraud, failed to tailor its audit approach to the risks in violation of GAAS, and issued an unqualified opinion on Adelphia’s financial statements while it knew or should have known that Adelphia: (a) failed to record all co-borrowing debt on its balance sheet or otherwise disclose that a portion had been excluded; (b) failed to disclose significant related party transactions by improperly netting related party payables and receivables; and (c) overstated its stockholders’ equity by $375 million; in settling the SEC action, Deloitte (i) paid $25 million into a disgorgement fund to be distributed to defrauded investors pursuant to a plan to be established pursuant to SOX §308(a) and court approval and (ii) undertook to establish specified policies and procedures to detect and report fraud pursuant to § 10A); KPMG LLP, Exchange Act Release No. 51,574, 85 SEC Docket 688 (Apr. 19, 2005), available at http://www.sec.gov/litigation/admin/34-51574.pdf (adjudicating action against KPMG regarding revenue recognition issues in accounting for leases in audits of financial statements of Xerox Corporation and failing to report Xerox’s failures to comply with GAAP under § 10A; in settlement KPMG agreed to (i) avoid circumstances where a client may improperly influence the firm’s assignment of engagement partners; (ii) create additional lines of communication within the firm to allow KPMG professionals to raise issues, which they may believe have not been adequately addressed at the engagement team level, to a more senior level within the firm, and establish “Whistle-blower” channels of communication; (iii) ensure that KPMG has policies and procedures designed to provide reasonable assurance that workpapers prepared in connection with the audits of the financial statements of public companies include documentation of significant consultations with KPMG’s Department of Professional Practice, firm specialists or others within or without the firm; (iv) provide training to its audit professionals concerning evaluation of audit evidence in a situation involving period-ending material adjustments by management to a company’s original accounting system entries; and (v) disseminate to all audit professionals, and incorporate in its training for new audit professionals, requirements that auditors of public company clients at least annually reassess a client’s justification for client accounting practices which are not in accordance with GAAP and assess the materiality of such departures; PricewaterhouseCoopers LLP, Exchange Act Release No. 49,678, 82 SEC Docket 2954 (May 11, 2004) (adjudicating action against PwC in connection with audit of the Warnaco Group’s financial statements from 1998 for failure to correctly characterize the cause of an inventory overstatement as resulting from internal control deficiencies as opposed to changed accounting rules, as misrepresented by Warnaco in a press release); Grant Thornton LLP, Securities Act Release No. 8355, Exchange Act Release No. 49,101, 81 SEC Docket 3441 (Jan. 20, 2004) (adjudicating administrative proceeding against Grant Thornton for aiding and abetting fraud and violating Section 10A by failing to obtain sufficient audit evidence despite “red flags” that client failed to disclose material related party transactions; Richard P. Scalzo, CPA, Exchange Act Release No. 48,328, 80 SEC Docket 2479 (Aug. 13, 2003) (holding auditor permanently barred from public practice based on audits of Tyco between 1997 and 2001 in which he became aware of facts that put him on notice regarding the integrity of Tyco’s management but failed to perform additional audit procedures or reevaluate his risk assessment); Warren Martin, CPA, Exchange Act Release No. 48,311, 80 SEC Docket 2440 (Aug. 8, 2003) (holding auditor suspended from public practice for two years for undue reliance upon management representations regarding the interpretation of contracts, thereby ignoring “unambiguous contractual language” that affected revenue recognition and led to a $66 million restatement); Phillip G. Hirsch, CPA, Exchange Act Release No. 47,901, 80 SEC Docket 805 (May 22, 2003) (suspending PwC auditor for one year in settlement of allegations that he did not ensure that sufficient audit procedures were conducted in light of PwC’s risk of fraud assessment and that he placed undue reliance on management representations despite awareness of evidence “from which he should have realized further audit work was required.”); SEC v. KPMG, 79 SEC Docket 1555 (Jan. 29, 2003) (seeking civil injunction against KPMG and disgorgement of fees and civil penalties in connection with the firm’s audit of Xerox based on allegation that auditors had evidence of manipulation of financial results and failed to ask Xerox to justify departures from GAAP); Barbara Horvath, CPA, Exchange Act Release No. 45,197 (Dec. 27, 2001) (examining a Deloitte & Touche auditor for placing reliance on management representations as her principal source of audit evidence for the company’s capitalization of expenses which, it turned out, were fraudulent).


and critical gatekeeping role.25

D. PCAOB

Besides the SEC’s Enforcement Division, the auditors’ newest regulator has put the industry on notice of its expectations with respect to fraud. The PCAOB was established under SOX § 101 to inspect, investigate, and discipline auditors conducting public company audits.26 In an August 2, 2004 interview, PCAOB Chairman William McDonough stated his view as to the auditor’s obligation to detect client fraud:

We have a very clear view that it is their job [to detect fraud]. If we see fraud that wasn’t detected and should have been, we will be very big on the tough and not so [big] on the love. . . . [A]uditors [need to] understand that, with relatively few exceptions, they should find it. To me, the relatively few exceptions are those cases where you would have some extremely dedicated, capable crooks. In most cases, though, the crooks either are not that smart or they don’t cover their tracks that well.27

Under SOX and the PCAOB’s implementing regulations, any violation of laws, rules or policies by individual auditors or firms detected during inspections of selected audit and review engagements is to be identified in a written report and may be handed over to the SEC or other regulatory authorities and become the subject of further investigation and disciplinary proceedings.28 The PCAOB has stated that inspections will assess compliance at all levels—

25 Stephen M. Cutler, Director of SEC Division of Enforcement, The Themes of Sarbanes-Oxley as Reflected in

the Commission’s Enforcement Program, Speech at the UCLA School of Law (Sept. 20, 2004), available at http://www.sec.gov/news/speech/spch092004smc.htm. Speeches by SEC members or staff are the expressions of the speakers themselves, and are not to be construed as representations of the Commission itself.

26 SOX §§ 101–05, 15 U.S.C. §§ 7211–15 (Supp. 2002). History: SOX § 105 granted the PCAOB broad investigative and disciplinary authority over registered firms and those firms’ partners, principals, and employees. 15 U.S.C. § 7215(b)(1) (Supp. 2002). On September 29, 2003 the PCAOB adopted Rules on Investigations and Adjudications in PCAOB Release No. 2003-015, which on May 14, 2004 the SEC approved 1934 Act Release No. 34-49704. PCAOB Rulemaking: Public Company Accounting Oversight Board; Order Approving Proposed Rules Relating to Investigations and Adjudications, Exchange Act Release No. 49,704, 82 SEC Docket 3076 (May 14, 2004). In Free Enterprise Fund v. Public Company Accounting Oversight Board, D.D.C., No. 06 Civ. 00217 (Sept. 1, 2006), the constitutionality of the PCAOB was challenged on grounds that PCAOB’s existence violates the appointments clause, the general separation of powers principle and the non-delegation doctrine of the U.S. Constitution. The SEC and U.S. Department of Justice have filed briefs supporting the constitutionality of the PCAOB. See 38 Sec. Reg. & L. Rep. (BNA) No. 37, at 1573 (Sept. 18, 2006). On August 22, 2008, in Free Enterprise Fund v. Public Company Accounting Oversight Board, 537 F.3d 667 (D.C. Cir. 2008), the U.S. Court of Appeals for the District of Columbia upheld SOX and the creation of the PCAOB as constitutional holding that the PCAOB does not encroach upon the appointments clause, separation of powers principles or the non-delegation doctrines of the U.S. Constitution.

27 The Enforcer, CFO.COM Aug. 2, 2004, available at http://www.cfo.com/printable/article.cfm/3015411/c_3046 616?f=options (emphasis added).

28 When the PCAOB believes that an act, practice or omission by a registered firm or individual auditor may violate SOX, PCAOB rules or other professional standards or any securities law or regulation pertaining to audit reports or to the duties of accountants, the PCAOB may open an investigation. See PCAOB R. 5101, available at http://www.pcaobus.org/Rules/Rules_of_the_Board/Section_5.pdf. Such an investigation can lead to disciplinary


i.e., actions, omissions, policies, and behavior patterns “from the senior partners to the line accountants.”29 The inspections will allow the PCAOB, in its own words, to “apply pressure to improve a firm’s audit practices.”30

All of these factors—the evolution of the law regarding auditors’ obligations with respect to client fraud, the SEC’s enforcement actions in recent years, and the introduction of the PCAOB’s expectations into the equation—indicate that auditors will continue to feel pressure to increase their role in monitoring and finding inappropriate corporate accounting behavior.

III. AUDITOR INDEPENDENCE; NON-AUDIT SERVICES (SOX TITLE II)

SOX amended the 1934 Act to prohibit a registered public accounting firm from performing specified non-audit services contemporaneously with an audit and requires audit committee pre-approval for other non-audit services. On January 28, 2003, the SEC issued Release No. 33-8183, adopting rules to implement SOX Title II (the “Title II Release” and the “Title II Rules”).31 These rules are applicable to all public companies regardless of size.32

A. Prohibited Non-Audit Services

SOX § 201 and the related Title II Rules prohibit a registered public accounting firm from providing to a public company, contemporaneously with the audit, the following non-audit services:33

(1) bookkeeping34 or other services related to the accounting records or financial statements35 of the audit client;36

proceedings, exposing the offending auditor or firm to penalties ranging from compulsory training and mandated quality control procedures to heavy civil fines and temporary or permanent suspension from audit practice. See PCAOB R. 5300, available at http://www.pcaobus.org/Rules/Rules_of_the_Board/Section_5.pdf.

29 Steven Berger, PCAOB—Beyond The First Year, MONDAY BUSINESS BRIEFING, July 15, 2004, available at 2004 WL 69983842.

30 PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD, ANNUAL REPORT, FISCAL YEAR 2003, at 4 (2004), available at http://www.pcaobus.org/About_the_PCAOB/Annual_Reports/2003.pdf.

31 Strengthening the Commission’s Requirements Regarding Auditor Independence, Securities Act Release No. 8183, Exchange Act Release No. 47,265, Investment Company Act Release No. 25,915 68 Fed. Reg. 6006 (Feb. 5, 2003), available at http://www.sec.gov/rules/final/33-8183.htm [hereinafter the Title II Release].

32 Id. 33 SOX § 201, amending 15 U.S.C.A. § 78j-1(g)–(h) (West Supp. 2007) [hereinafter SOX § 201]. 34 17 C.F.R. § 210.2-01(c)(4)(i) (2008). The Title II Rules utilize a definition of bookkeeping or other services

which focuses on the provision of services involving: (1) maintaining or preparing the audit client’s accounting records; (2) preparing financial statements that are filed with the SEC or the information that forms the basis of financial statements filed with the SEC; or (3) preparing or originating source data underlying the audit client’s financial statements.

35 In the Title II Release, the SEC noted:

an accountant’s independence would be impaired where the accountant prepared [an issuer’s] statutory financial statements if those statements form the basis of the financial statements that are filed with [the SEC]. Under these circumstances, an accountant or accounting firm who has prepared


(2) financial information systems design and implementation;37

(3) appraisal or valuation services, fairness opinions, or contribution-in-kind reports;38

(4) actuarial services;39

the statutory financial statements of an audit client is put in the position of auditing its own work when auditing the resultant U.S. GAAP financial statements.

Title II Release, supra, note 31, at 6011. 36 17 C.F.R. § 210.2-01(c)(4)(i) (2008). 37 17 C.F.R. § 210.2-01(c)(4)(ii) (2008). The SEC’s Title II Rules:

prohibit [an] accounting firm from providing any service related to the audit client’s information system unless it is reasonable to conclude that the results of these services will not be subject to audit procedures during an audit of the audit client’s financial statements. These rules do not preclude an accounting firm from working on hardware or software systems that are unrelated to the audit client’s financial statements or accounting records as long as those services are pre-approved by the audit committee.

. . .

[In the SEC’s view, d]esigning, implementing, or operating systems affecting the financial statements may place the accountant in a management role, or result in the accountant auditing his or her own work or attesting to the effectiveness of internal control systems designed or implemented by that accountant. For example, if an auditor designs or installs a computer system that generates the financial records, and that system generates incorrect data, the accountant is placed in a position of having to report on his or her firm’s own work. Investors may perceive that the accountant would be unwilling to challenge the integrity and efficacy of the client’s financial or accounting information collection systems that the accountant designed or installed.

However, this prohibition does not preclude the accountant from evaluating the internal controls of a system as it is being designed, implemented, or operated either as part of an audit or attest service or making recommendations to management. Likewise, the accountant would not be precluded from making recommendations on internal control matters to management or other service providers in conjunction with the design and installation of a system by another service provider.

Title II Release, supra, note 31, at 6011–12. 38 17 C.F.R. § 210.2-01(c)(4)(iii) (2008). Under Title II Rules:

[a]ppraisal and valuation services include any process of valuing assets, both tangible and intangible, or liabilities. [These services] include valuing, among other things, in-process research and development, financial instruments, assets and liabilities acquired in a merger, and real estate. Fairness opinions and contribution-in-kind reports are opinions and reports in which the firm provides its opinion on the adequacy of consideration in a transaction.

. . .

[The Title II R]ules do not prohibit an accounting firm from providing such services for non-financial reporting purposes (e.g., transfer pricing studies, cost segregation studies, and other tax-only valuations). Also, the rule[s] do[] not prohibit an accounting firm from utilizing its own valuation specialist to review the work performed by the audit client itself or an independent, third-party specialist employed by the audit client, provided the audit client or the client’s specialist (and not the specialist used by the accounting firm) provides the technical expertise that the client uses in determining the required amounts recorded in the client’s financial statements. In those instances, the accountant will not be auditing his or her own work because a third party or the audit client is the source of the financial information subject to the audit.

Title II Release, supra note 31, at 6012. 39 17 C.F.R. § 210.2-01(c)(4)(iv) (2008). The SEC believes that:


(5) internal audit outsourcing services;40

(6) management functions41 or human resources;42

when the accountant provides actuarial services for the client, he or she is placed in a position of auditing his or her own work. Accordingly, the [Title II R]ules . . . prohibit an accountant from providing to an audit client any actuarially-oriented advisory service involving the determination of amounts recorded in the financial statements and related accounts . . . other than assisting a client in understanding the methods, models, assumptions, and inputs used in computing an amount, unless it is reasonable to conclude that the results of these services will not be subject to audit procedures during an audit of the audit client’s financial statements.

[I]t is [permissible, however,] to advise the client on the appropriate actuarial methods and assumptions that will be used in the actuarial valuations[, while i]t is not appropriate for the accountant to provide the actuarial valuations for the audit client.

[Further,] the accountant may utilize his or her own actuaries to assist in conducting the audit provided the audit client uses its own actuaries or third-party actuaries to provide management with its actuarial capabilities.

Title II Release, supra note 31, at 6013. 40 17 C.F.R. § 210.2-01(c)(4)(v) (2008). The Title II Rules:

prohibit the accountant from providing to the audit client internal audit outsourcing services. This prohibition . . . include[s] any internal audit service that has been outsourced by the audit client that relates to the audit client’s internal accounting controls, financial systems, or financial statements, unless it is reasonable to conclude that the results of these services will not be subject to audit procedures during an audit of the audit client’s financial statements.

[While] . . . conduct[ing] . . . the audit in accordance with generally accepted auditing standards (“GAAS”), or when providing attest services related to internal controls, the auditor evaluates the company’s internal controls and, as a result, may make recommendations for improvements to the controls. Doing so is a part of the accountant’s responsibilities under GAAS or applicable attestation standards and, therefore, does not constitute an internal audit outsourcing engagement.

Along those lines, the prohibition on “outsourcing” does not preclude engaging the accountant to perform nonrecurring evaluations of discrete items or other programs that are not, in substance, the outsourcing of the internal audit function. For example, the company may engage the accountant, subject to the audit committee pre-approval requirements, to conduct “agreed-upon procedures” engagements related to the company’s internal controls, since management takes responsibility for the scope and assertions in those engagements. The prohibition also does not preclude the accountant from performing operational internal audits unrelated to the internal accounting controls, financial systems, or financial statements.

Title II Release, supra note 31, at 6013. 41 17 C.F.R. § 210.2-01(c)(4)(vi) (2008). The Title II Rules:

prohibit the accountant from acting, temporarily or permanently, as a director, officer, or employee of an audit client, or performing any decision-making, supervisory, or ongoing monitoring function for the audit client.

[The SEC] believe[s], however, that services in connection with the assessment of internal accounting and risk management controls, as well as providing recommendations for improvements, do not impair an accountant’s independence. Accountants must gain an understanding of their audit clients’ systems of internal controls when conducting an audit in accordance with GAAS. With this insight, accountants often become involved in diagnosing, assessing, and recommending to audit committees and management ways in which their audit clients’ internal controls can be improved or strengthened. The resulting improvements in the audit clients’ controls not only result in improved financial reporting to investors but also can facilitate the performance of high quality audits. [As a result, the Title II Rules] allow accountants to assess the effectiveness of an audit client’s internal controls and to recommend improvements in the design and implementation of internal controls and risk management controls.


(7) broker or dealer, investment adviser, or investment banking services;43

(8) legal services44 and expert services unrelated to the audit;45

[D]esigning and implementing internal accounting and risk management controls is fundamentally different from obtaining an understanding of the controls and testing the operation of the controls, which is an integral part of any audit of [a company’s] financial statements. . . . Likewise, design and implementation of these controls involves decision-making and, therefore, is different from recommending improvements in the internal accounting and risk management controls of an audit client (which is permissible, if pre-approved by the audit committee).

Title II Release, supra note 31, at 6014. 42 17 C.F.R. § 210.2-01(c)(4)(vii) (2008). The Title II Rules:

provide that an accountant’s independence is impaired with respect to an audit client when the accountant searches for or seeks out prospective candidates for managerial, executive, or director positions; acts as negotiator on the audit client’s behalf, such as determining position, status, compensation, fringe benefits, or other conditions of employment; or undertakes reference checks of prospective candidates. Under the [Title II Rules], an accountant’s independence also is impaired when the accountant engages in psychological testing [on behalf of the audit client], . . . other formal testing or evaluation programs, or recommends or advises the audit client to hire a specific candidate for a specific job.

Title II Release, supra note 31, at 6014. 43 17 C.F.R. § 210.2-01(c)(4)(viii) (2008). The SEC considers:

[s]elling—directly or indirectly—an audit client’s securities [to be] incompatible with the accountant’s responsibility of assuring the public that the company’s financial condition is fairly presented. When an accountant, in any capacity, recommends to anyone (including non-audit clients) that they buy or sell the securities of an audit client or an affiliate of the audit client, the accountant has an interest in whether those recommendations were correct. That interest could affect the audit of the client whose securities, or whose affiliate’s securities, were recommended.

Title II Release, supra note 31, at 6015. 44 17 C.F.R. § 210.2-01(c)(4)(ix) (2008). In the Title II Release, the SEC noted:

a lawyer’s core professional obligation is to advance clients’ interests. . . . [A]n individual cannot be both a zealous legal advocate for management or the client company and maintain the objectivity and impartiality that are necessary for an audit.

. . .

[Thus, under the Title II Rules], an accountant is prohibited from providing to an audit client any service that, under circumstances in which the service is provided, could be provided only by someone licensed, admitted, or otherwise qualified to practice law in the jurisdiction in which the service is provided.

Title II Release, supra note 31, at 6015. 45 17 C.F.R. § 210.2-01(c)(4)(x) (2008). The Title II Rules:

prohibit an accountant from providing expert opinions or other services to an audit client, or a legal representative of an audit client, for the purpose of advocating that audit client’s interests in litigation, or regulatory or administrative investigations or proceedings. For example, under this rule, an auditor’s independence would be impaired if the auditor were engaged to provide forensic accounting services to the audit client’s legal representative in connection with the defense of an investigation by the SEC’s Division of Enforcement. Additionally, an accountant’s independence would be impaired if the audit client’s legal counsel, in order to acquire the requisite expertise, engaged the accountant to provide such services in connection with any litigation, proceeding[,] or investigation.

[The Title II Rules] do not, however, preclude an audit committee or, at its direction, its legal counsel, from engaging the accountant to perform internal investigations or fact-finding engagements. These types of engagements may include, among others, forensic or other fact-finding work that results in the issuance of a report to the audit client. The involvement by the accountant in this capacity


With respect to other non-audit services, SOX § 201 states that “[a] registered public accounting firm may engage in any non-audit service, including tax services, that is not described in any of paragraphs (1) through (9) [listed above] . . . for an audit client, only if the activity is approved in advance by the audit committee of the issuer[.]”46 “[T]here has been considerable debate regarding whether an accountant’s provision of tax services for an audit client can impair the accountant’s independence.”47

The Title II Release “reiterates [the SEC’s] long-standing position that an accounting firm can provide tax services to its audit clients without impairing the firm’s independence[, and states that] accountants may continue to provide tax services such as tax compliance, tax planning, and tax advice to audit clients, subject to the normal audit committee pre-approval requirements. . . .48 Additionally, [the Title II Rules] require [issuers] to disclose the amount

generally requires performing procedures that are consistent with, but more detailed or more comprehensive than, those required by [generally accepted auditing standards (“GAAS”)]. Performing such procedures is consistent with the role of the independent auditor and could improve audit quality. If, subsequent to the completion of such an engagement, a proceeding or investigation is initiated, the accountant may allow its work product to be utilized by the audit client and its legal counsel without impairing the accountant’s independence. The accountant, however, may not then provide additional services, but may provide factual accounts or testimony about the work performed.

Accordingly, [the Title II Rules do] not prohibit an accountant from assisting the audit committee in fulfilling its responsibilities to conduct its own investigation of a potential accounting impropriety. For example, if the audit committee is concerned about the accuracy of the inventory accounts at a subsidiary, it may engage the auditor to conduct a thorough inspection and analysis of those accounts, the physical inventory at the subsidiary, and related matters without impairing the auditor’s independence.

[Recognizing] that auditors have obligations under [SOX] and GAAS to search for fraud that is material to an issuer’s financial statements and to make sure the audit committee and others are informed of their findings[, the Title II Rules permit a]uditors [to] conduct these procedures whether they become aware of a potential illegal act as a result of audit, review[,] or attestation procedures they have performed or as a result of the audit committee expressing concerns about a part of the company’s operations or compliance with the company’s financial reporting system. . . . Should litigation arise or an investigation commence during the time . . . that the auditors are conducting such procedures, [the SEC] would not deem the completion of these procedures to be prohibited expert services so long as the auditor remains in control of his or her work and that work does not become subject to the direction or influence of legal counsel for the issuer.

Title II Release, supra note 31, at 6016. 46 SOX § 201, supra note 33 (emphasis added). 47 Title II Release, supra note 31, at 6016. 48 With respect to accounting firm-developed income tax preparation software, the Staff commented in response

to Questions 18 and 19:

Question 18

Q: Some accounting firms have developed their own proprietary income tax preparation software. The software is used to facilitate the preparation of company income tax returns for various tax jurisdictions. Can an accounting firm license or sell its proprietary income tax preparation software to an audit client?

A: Licensing or selling income tax preparation software to an audit client would be subject to audit committee pre-approval requirements for permissible tax services. To the extent that the audit client’s audit committee pre-approves the acquisition of the income tax preparation software from the accounting firm, it would be permissible for the accounting firm to license or sell its income tax preparation software to an audit client, so long as the functionality is, indeed, limited to preparation of returns for filing of tax returns. If the software performs additional functions, each function should be evaluated for its potential effect on the auditor’s independence (see Question 19).


of fees paid to the accounting firm for tax services.”49

The Title II Release further comments that “merely labeling a service as a ‘tax service’ will not necessarily eliminate its potential to impair [auditor] independence[, and that a]udit committees and accountants should understand that providing certain tax services to an audit client [could] . . . impair the independence of the accountant.50 Specifically, accountants would impair their independence by representing an audit client before a tax court, district court, or federal court of claims.51 In addition, audit committees [are cautioned to] scrutinize carefully the retention of an accountant in a [tax-avoidance] transaction initially recommended by the accountant, the tax treatment of which may [be dicey].”52

The SEC’s “principles of independence with respect to [non-audit] services provided by auditors are largely predicated on three basic principles, violations of which would impair the auditor’s independence: (1) an auditor cannot function in the role of management; (2) an auditor cannot audit his or her own work; and (3) an auditor cannot serve in an advocacy role for his or her client.”53

The PCAOB has adopted rules, which have been approved by the SEC54 and would amplify on these independence principals as follows:

No Contingent Fees (PCAOB Rule 3521): An auditor would not be independent if he or

Question 19

Q: Some accounting firms have developed software modules which extend the functionality of the proprietary income tax preparation software. One of the additional software modules that has been developed by some firms takes the information used in preparing the tax return and generates some or all of the information needed to prepare the tax accrual and disclosures related to income taxes that will appear in the company’s financial statements. Can the accounting firm license or sell this type of module to an audit client either concurrently with or subsequent to the licensing or sale of its income tax preparation software?

A: No. Since the purpose of the module is to develop the information needed to prepare a significant element of the company’s financial statements, licensing or selling the module to an audit client would constitute the design and implementation of a financial information system, which is a prohibited non-audit service. It should be noted that the prohibition exists whether or not the module is integrated with, linked to, feeds the company’s general ledger system, or otherwise prepares entries on behalf of the audit client (even if those entries are required to be manually recorded by client personnel). The output of the module aggregates source data or generates information that can be significant to the company’s financial statements taken as a whole.

Office of SEC Chief Accountant Application of the January 2003 Rules on Auditor Independence; Frequently Asked Questions, http://www.sec.gov/info/accountants/ocafaqaudind080703.htm (Aug. 13, 2003) [hereinafter Auditor Independence FAQ].

49 Title II Release, supra note 31, at 6017. 50 Id. (internal quotations omitted). 51 Id. 52 Id. 53 Id. at 6010. 54 Public Company Accounting Oversight Board; Order Approving Proposed Ethics and Independence Rules

Concerning Independence, Tax Services, and Contingent Fees and Notice of Filing and Order Granting Accelerated Approval of the Amendment Delaying Implementation of Certain of these Rules, Exchange Act Release No. 53,677, 71 Fed. Reg. 23,971 (Apr. 19, 2006), available at http://www.sec.gov/rules/pcaob/2006/34-53677.pdf.


she entered into a contingent fee arrangement, directly or indirectly, with an audit client.55 A “contingent fee” would include any fee established for the sale of a product or the performance of a service pursuant to an arrangement in which no fee would be charged unless, or the amount thereof is dependent upon, a specified finding or result is attained.56

No Aggressive Tax Transaction (PCAOB Rule 3522): An auditor is prohibited from “providing any non-audit services to an audit client related to the marketing, planning, or opining in favor of the tax treatment”57 of any transaction that: (i) is a listed transaction (defined in Treasury Regulations § 1.6011-4(b)(2) as a transaction substantially similar to those identified therein as tax avoidance transactions), (ii) is a confidential transaction (defined in Treasury Regulations § 1.6011-4(b)(3)(ii) as a transaction on which disclosure limitations are imposed to protect the advisor’s tax strategies), or (iii) would be considered an aggressive tax position transaction (i.e., a transaction, a significant purpose of which is tax avoidance, unless the proposed tax treatment is at least more likely than not to be allowable under applicable tax laws).58

Tax Services for Management (PCAOB Rule 3523): An audit firm may not provide any tax service to any individual who performs a financial reporting oversight role for an audit client, or an immediate family member of such an individual, unless such individual is in that role solely as a member of the issuer’s board of directors.59

Audit Committee Pre-approval of Tax Services (PCAOB Rule 3524): In connection with seeking audit committee pre-approval to perform any permissible tax service for an audit client, a registered public accounting firm is required to “(a) describe, in writing, to the audit committee of the issuer (i) the scope of the service, the fee structure for the engagement, and any side letter or other amendment to the engagement letter, or any other agreement (whether oral, written, or otherwise) between the accounting firm and the audit client, relating to the service; and (ii) any compensation arrangement or other agreement, such as a referral agreement, a referral fee or fee-sharing arrangement, between the . . . accounting firm (or an affiliate of the firm) and any person (other than the audit client) with respect to the promoting, marketing, or recommending of a transaction covered by the service; (b) discuss with the audit committee of the issuer the potential effects of the services on the independence of the accounting firm; and (c) document the substance of its discussion with the audit committee of the issuer.”60

B. Audit Committee Pre-Approval of All Audit and Non-Audit Services

SOX § 202 requires audit committee pre-approval of all auditing services (including providing comfort letters in connection with securities underwritings or statutory audits required for insurance companies for purposes of state law) and all non-audit services provided

55 Id. at 23,971. 56 Id. 57 Id. 58 See id. 59 Id. at 23,972. 60 PCAOB R. 3524.


by the auditor.61 The audit committee may delegate the pre-approval responsibility to a subcommittee of one or more independent directors.62 There is a de minimis exception with respect to the provision of non-audit services for an issuer if: (i) the aggregate amount constitutes not more than five percent of the total amount paid to the auditor during the fiscal year in which the non-audit services are provided; (ii) such services were not recognized as non-audit services by the issuer at the time of the engagement; and (iii) such services are promptly brought to the attention of the audit committee and approved prior to the completion of the audit by the audit committee or by one or more members of the audit committee to whom authority to grant such approvals has been delegated by the audit committee.63

The Title II Release recognizes that “management has [historically] retained the accounting firm, negotiated the audit fee, and contracted with the accounting firm for other services[, but the Release comments that SOX § 202 changes that practice by] requir[ing] audit committees [to] pre-approve the services—both audit and permitted non-audit—of the accounting firm.”64 The SEC believes that the SOX § 202 change may both “facilitate communications among the board of directors, management, internal auditors, and independent accountants[, as well as] enhance auditor independence from management by [vesting in the audit committee the power and responsibility of] appointing, compensating, and overseeing the work of the independent accountants.”65

As adopted, the Title II Rules “require that the audit committee pre-approve all permissible non-audit services and all audit, review, or attest engagements required under the securities laws. . . .66 Specifically, [t]he rules require that before the accountant is engaged by the issuer or its subsidiaries to render the service, the engagement is:

• Approved by the issuer’s . . . audit committee; or

• Entered into pursuant to pre-approval policies and procedures established by the audit committee of the issuer . . . , provided the policies and procedures are detailed as to the particular service, the audit committee is informed of each service, and such policies and procedures do not include delegation of the audit committee’s responsibilities to management.”67

61 SOX § 202, amending 15 U.S.C.A. § 78j-1(i) (West Supp. 2007) [hereinafter SOX § 202].

[T]he audit committee of [a] parent company [may] serve as the audit committee of the parent company and the wholly-owned subsidiaries. In this situation, the subsidiary’s disclosure should include the pre-approval policies and procedures of the subsidiary and, also should include the pre-approval policies and procedures of the parent company.

See Auditor Independence FAQ, supra note 48, at Question 20. 62 SOX § 202, supra note 61. 63 Id. 64 Title II Release, supra note 31, at 6022. 65 Id. 66 Id. 67 Title II Release, supra note 31, at 6022. The SEC Chief Accountant has commented that pre-approval policies

may not be based on monetary limits and must be detailed enough for the audit committee to know precisely what services are being pre-approved and the impact thereof on auditor independence. See Auditor Independence FAQ,


The Title II Rules recognize audit services to be broader than those services required to perform an audit pursuant to GAAS.68 For example, SOX § 202 identifies services related to the issuance of comfort letters and services related to statutory audits required for insurance companies for purposes of state law as audit services.69

Furthermore, under the Title II Rules, audit services also would include services performed to fulfill the accountant’s responsibility under GAAS.70 For example, in some situations, a tax partner may be involved in reviewing the tax accrual that appears in the company’s financial statements [as] part of the audit process. Consultation with the national

supra note 48. Under Questions 22, 23, and 24 the Staff wrote:

Question 22

Q: The Commission’s rules require the audit committee to pre-approve all services provided by the independent auditor. In doing so, the audit committee can pre-approve services using pre-approval policies and procedures. Can the audit committee use monetary limits as the basis for establishing its pre-approval policies and procedures?

A: The Commission’s rules include three requirements that must be followed in the audit committee’s use of pre-approval through policies and procedures. First, the policies and procedures must be detailed as to the particular services to be provided. Second, the audit committee must be informed about each service. Third, the policies and procedures cannot result in the delegation of the audit committee’s authority to management. Pre-approval policies and procedures that do not comply with all three of these requirements are in contravention of the Commission’s rules. Therefore, monetary limits cannot be the only basis for the pre-approval policies and procedures. The establishment of monetary limits would not, alone, constitute policies that are detailed as to the particular services to be provided and would not, alone, ensure that the audit committee would be informed about each service.

Question 23

Q: Can the audit committee’s pre-approval policies and procedures provide for broad, categorical approvals (e.g., tax compliance services)?

A: No. The Commission’s rules require that the pre-approval policies be detailed as to the particular services to be provided. Use of broad, categorical approvals would not meet the requirement that the policies must be detailed as to the particular services to be provided.

Question 24

Q: How detailed do the pre-approval policies need to be?

A: The determination of the appropriate level of detail for the pre-approval policies will differ depending upon the facts and circumstances of the issuer. However, a key requirement is that the policies cannot result in a delegation of the audit committee’s responsibility to management. As such, if a member of management is called upon to make a judgment as to whether a proposed service fits within the pre-approved services, then the pre-approval policy would not be sufficiently detailed as to the particular services to be provided. Similarly, pre-approval policies must be designed to ensure that the audit committee knows precisely what services it is being asked to pre-approve so that it can make a well-reasoned assessment of the impact of the service on the auditor’s independence. For example, if the audit committee is presented with a schedule or cover sheet describing services to be pre-approved, that schedule or cover sheet must be accompanied by detailed back-up documentation regarding the specific services to be provided.

Auditor Independence FAQ, supra note 48. 68 Title II Release, supra note 31, at 6022. 69 Id. 70 Id. at 6030.


office or other technical reviewers to reach an audit judgment also constitutes an audit service.

In contrast, where an issuer is evaluating a proposed transaction and asks the independent accountant to evaluate the accounting for the proposed transaction, those services would not be considered to be audit services.

Although the audit committee must pre-approve all services, SOX § 202 permits the audit committee to establish policies and procedures for pre-approval provided they are detailed as to the particular service and designed to safeguard the continued independence of the accountant.71 For example, SOX § 202 allows for one or more audit committee members who are independent directors to pre-approve the service. Decisions made by the designated audit committee members must be reported to the full audit committee at each of its scheduled meetings.72

Like SOX § 202, the Title II Rules include a de minimis exception which waives the pre-approval requirements for non-audit services provided that: (1) all such services do not aggregate to more than five percent of total revenues paid by the audit client to its accountant in the fiscal year when services are provided; (2) the services were not recognized as non-audit services at the time of the engagement; and (3) the services are promptly brought to the attention of the audit committee and approved prior to the completion of the audit by the audit committee or one or more designated representatives.73 The audit committee’s policies for pre-approval of services should be disclosed in the issuer’s Form 10-K annual reports.74

Until the adoption of the Title II Rules proxy disclosure rules required that an issuer disclose, for the most recent fiscal year, the professional fees paid for both audit and non-audit services to its principal independent accountant. As a result of the requirements of SOX and partly in response to public comment received by the SEC on proxy disclosure requirements since their adoption in 2000, the Title II Rules now require issuers to report fees spent on: (1) Audit Fees; (2) Audit-Related Fees; (3) Tax Fees; and (4) All Other Fees.75

Additionally, other than for the audit category, the issuer is required to describe, in qualitative terms, the types of services provided under the remaining three categories.76 This

71 Id. at 6022 (internal quotations omitted). 72 Id. 73 Id. at 6023. 74 Id. 75 Id. at 6030. Previously, issuers were required to disclose only “Audit Fees,” “Financial Systems Design and

Implementation Fees,” and “All Other Fees.” 76 To provide guidance to issuers in making the required audit fee disclosures, the SEC has provided some

guidance as to fee disclosures. Auditor Independence FAQ, supra note 48. The Staff responded to questions 30, 31, and 32 as follows:

Question 30

Q: What fee disclosure category is appropriate for professional fees in connection with an audit of the financial statements of a carve-out entity in anticipation of a subsequent divestiture?

A: The release establishes a new category, “Audit-Related Fees,” which enables registrants to present the


information is now required for the two most recent years, and must be provided either in the issuer’s proxy statement or its Form 10-K annual report.77

As noted above, the issuer must provide disclosure of the audit committee’s pre-approval policies and procedures. Additionally, to the extent that the audit committee has applied the de minimis exception, the issuer must disclose the percentage of the total fees paid to the independent accountant where the de minimis exception was used.78 This information should be provided by category.79

The information must be included in an issuer’s Form 10-K annual report.80 However, because the SEC views the information as relevant to a decision to vote for a particular director or to elect, approve, or ratify the choice of an independent public accountant, the SEC is also requiring that the disclosure discussed above be included in an issuer’s proxy statement. Since the information is included in Part III of annual reports on Form 10-K, domestic companies are able to incorporate the required disclosures from the proxy or information statement into the

audit fee relationship with the principal accountant in a more transparent fashion. In general, “Audit-Related Fees” are assurance and related services (e.g., due diligence services) that traditionally are performed by the independent accountant. More specifically, these services would include, among others: employee benefit plan audits, due diligence related to mergers and acquisitions, accounting consultations and audits in connection with acquisitions, internal control reviews, attest services related to financial reporting that are not required by statute or regulation and consultation concerning financial accounting and reporting standards. Fees for the above services would be disclosed under “Audit-Related Fees.”

Question 31

Q: Would fees paid to the audit firm for operational audit services be included in “Audit-Related Fees”?

A: No. “Audit-Related Fees” are fees for assurance and related services by the principal accountant that are traditionally performed by the principal accountant and which are “reasonably related to the performance of the audit or review of the registrant’s financial statements.” Operational audits would not be related to the audit or review of the financial statements and, therefore, the fees for these services should be included in “All Other Fees.” As required by the rules, the registrant would need to include a narrative description of the services included in the “All Other Fees” category.

Question 32

Q: The Commission’s new independence rules require companies to disclose fees paid to the principal auditor in four categories (“audit”, “audit-related”, “tax”, and “all other”) for the two most recent years. Previously, companies were required to disclose fees paid to the principal auditor in three categories and only for the most recent year. When are the new fee disclosure requirements effective?

A: The release text indicates that the new disclosure requirements are effective for periodic annual filings and proxy or information statement filings for the first fiscal year ending after December 15, 2003. Thus, the new disclosure requirements are not mandatory until the calendar-year 2003 periodic annual filings are made in 2004. However, the release text also indicates that “we encourage issuers . . . to adopt these disclosure provisions earlier.” Thus, companies may, but are not required, to provide the new disclosures for proxies and other periodic annual filings that are made prior to the effective date for the new disclosures.

Auditor Independence FAQ, supra note 48. 77 Title II Release, supra note 31, at 6031. 78 Id. 79 Id. 80 Id.


annual report on Form 10-K.81

C. Audit Partner Rotation

SOX § 203 mandates rotation every five years of both the lead audit partner working for the audit client and the audit partner responsible for reviewing the audit,82 but does not require rotation of registered public accounting firms, although the PCAOB may end up requiring such rotation.83 The Title II Rules expand SOX § 203 by requiring not only that both the lead and the concurring partners rotate after five years, but that they also are subject to a five-year time-out period after the rotation.84 Further, the Title II Rules require rotation after seven years, with a two year post-rotation time-out, for other partners on the audit engagement team who have responsibility for decision-making on significant auditing, accounting, and reporting matters that affect the financial statements or who maintain regular contact with management or the audit committee (together with the lead and concurring partner, “audit partners”).85 The mandatory audit partner rotation does not extend to less important partners on the audit engagement teams, specialty partners, and national office partners.86

81 Id. 82 SOX § 203, amending 15 U.S.C.A. 78j-1(j) (West Supp. 2007) [hereinafter SOX § 203]; Title II Release, supra

note 31, at 6017. 83 Title II Release, supra note 31 at 6018. 84 Id. 85 Tax and other partners are deemed “audit partners” under this definition if they are “relationship partners” with

a high degree of contact with the issuer’s management or audit committee. See Auditor Independence FAQ, supra note 48. In response to questions 10 and 11 the Staff commented:

Question 10

Q: Generally, a tax or other specialty partner is not included within the definition of “audit partner.” Are there circumstances where a tax or other specialty partner would be included within the definition of “audit partner”? If so, what are the consequences?

A: The term “audit partner” is significant in that it establishes the partners who are subject to the partner rotation requirements and the partner compensation requirements. The discussion of “audit partner” in the release text states: “the term audit partner would include the ‘lead’ and ‘concurring’ partners, partners such as ‘relationship’ partners who serve the client at the issuer or parent level.” “Relationship” partners have a high level of contact with management and the audit committee of the issuer. Therefore, a tax or other specialty partner who serves as the “relationship” partner would be included within the scope of the definition of “audit partner.”

Question 11

Q: What are the rotation requirements for the “relationship” partner who is not the “lead” or “concurring” partner?

A: As discussed in question 10, the “relationship” partner meets the definition of an “audit partner” and, therefore, is subject to the partner rotation requirements. “Lead” and “concurring” partners are required to rotate off an engagement after a maximum of five years in either capacity and, upon rotation, must be off the engagement for five years. Other “audit partners” are subject to rotation after seven years on the engagement and must be off the engagement for two years. A “relationship” partner who is not the “lead” or “concurring” partner would, therefore, be subject to the seven years of service, two years time out rotation requirement.

Auditor Independence FAQ, supra note 48. 86 Title II Release, supra note 31, at 6019–20.


The rotation requirements applicable to the lead partner are effective for the first fiscal year ending after the effective date of the Title II Rules.87 Furthermore, in determining when the lead partner must rotate, time served in the capacity of lead partner prior to the effective date of these rules is included.88 For example, for a lead partner serving a calendar year audit client, if 2006 was that partner’s fifth year as lead partner for that audit client, the partner would be able to complete the current year’s audit but must rotate off for the 2007 engagement.89

D. Auditor Reports to Audit Committees

SOX § 204 requires auditor reports to audit committees regarding “(a) all critical accounting policies and practices to be used and (b) all alternative treatments of financial information within generally accepted accounting principles [for financial reporting in the United States (“GAAP”)] that have been discussed with management. . . .”90 In response to SOX § 204, the SEC “amend[ed] Regulation S-X to require each [registered] public accounting firm . . . that audits an issuer’s financial statements to report[, prior to the filing of such report with the SEC,] to the issuer’s . . . audit committee: (1) all critical accounting policies and practices used by the issuer;91 (2) all . . . alternative accounting treatments [of financial information] within GAAP that have been discussed with management, including the ramifications of the use of [such] alternative treatments [and disclosures] and the treatment preferred by the accounting firm;92 and (3) other material written communications between the

87 Id. at 6021. 88 Id. 89 Id. 90 SOX § 204, amending 15 U.S.C.A. § 78j-1(k) (West Supp. 2007) [hereinafter SOX § 204]; Title II Release,

supra note 31, at 6007. 91 In December 2001, the SEC issued cautionary advice regarding each issuer disclosing in the Management’s

Discussion and Analysis section of its Form 10-K annual report those accounting policies that management believes are most critical to the preparation of the issuer’s financial statements. Action: Cautionary Advice Regarding Disclosure About Critical Accounting Policies, Securities Act Release No. 8040, Exchange Act Release No. 45,149, 66 Fed. Reg. 65,013 (Dec. 17, 2001), available at http://www.sec.gov/rules/other/33-8040.htm [hereinafter December 2001 Cautionary Guidance]. The December 2001 Cautionary Guidance indicated that “critical” accounting policies are those that “are both most important to the portrayal of the company’s financial condition and results and . . . require management’s most difficult, subjective, or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.” Id. at 65,013. In the Title II Release, the SEC noted:

refer[ence should be made] to the December 2001 Cautionary Guidance to determine the types of matters that should be communicated to the audit committee under [the Title II Rules]. [While there is no] require[ment] that [the] discussions follow a specific form or manner, [the Title II Release] expect[s], at a minimum, that the discussion of critical accounting estimates and the selection of initial accounting policies will include the reasons why estimates or policies meeting the criteria in the Guidance are or are not considered critical and how current and anticipated future events impact those determinations. In addition, [it is] anticipate[d] that the communications regarding critical accounting policies will include an assessment of management’s disclosures along with any significant proposed modifications by the accountants that were not included.

Title II Release, supra note 31, at 6028. 92 Title II Release, supra note 31, at 6027. The Title II Rules:

require communication, either orally or in writing, by accountants to audit committees of all


accounting firm and management of the issuer.”93

In describing the role and responsibilities of the audit committee, the Title II Release includes the following quotation from Warren Buffett:

Their function . . . is to hold the auditor’s feet to the fire. And, I suggest . . . the audit committee ask [questions] of the auditors [including]: if the auditor were solely responsible for preparation of the company’s financial statements, would they have been prepared in any way differently than the manner selected by management? They should inquire as to both material and non-material differences. If the auditor would have done anything differently than management, then explanations should be made

alternative treatments within GAAP for policies and practices related to material items that have been discussed with management, including the ramifications of the use of such alternative treatments and disclosures and the treatment preferred by the accounting firm[, including] recognition, measurement, and disclosure considerations related to the accounting for specific transactions as well as general accounting policies.

[C]ommunications regarding specific transactions should identify, at a minimum, the underlying facts, financial statement accounts impacted, and applicability of existing corporate accounting policies to the transaction. In addition, if the accounting treatment proposed does not comply with existing corporate accounting policies, or if an existing corporate accounting policy is not applicable, then an explanation of why the existing policy was not appropriate or applicable and the basis for the selection of the alternative policy should be discussed. Regardless of whether the accounting policy selected preexists or is new, the entire range of alternatives available under GAAP that were discussed by management and the accountants should be communicated along with the reasons for not selecting those alternatives. If the accounting treatment selected is not, in the accountant’s view, the preferred method, . . . the reasons why the accountant’s preferred method was not selected by management also [should] be discussed.

Communications regarding general accounting policies should focus on the initial selection of and changes in significant accounting policies, as required by GAAS, and should include the impact of management’s judgments and accounting estimates, as well as the accountant’s judgments about the quality of the entity’s accounting principles. The discussion of general accounting policies should include the range of alternatives available under GAAP that were discussed by management and the accountants along with the reasons for selecting the chosen policy. If an existing accounting policy is being modified, then the reasons for the change also should be communicated. If the accounting policy selected is not the accountant’s preferred policy, then [the SEC] expect[s] the discussions to include the reasons why the accountant considered one policy to be preferred but that policy was not selected by management.

Title II Release, supra note 31, at 6028–29. 93 Id. at 6029. In the Title II Release, the SEC noted:

Examples of additional written communications that [the Title II Release] expects will be considered material to an issuer include:

● Management representation letter;

● Reports on observations and recommendations on internal controls;

● Schedule of unadjusted audit differences, and a listing of adjustments and reclassifications not recorded, if any;

● Engagement letter; and

● Independence letter. Id.


of management’s argument and the auditor’s response.94

E. Prohibited Employment Relationships

SOX § 206 prohibits “a registered public accounting firm [from] perform[ing] . . . audit service[s for a public company] if [the issuer’s] chief executive officer, controller, chief financial officer, chief accounting officer, or any person serving in an equivalent position for the issuer [had been] employed by [such] firm and participated in any capacity in the audit of that issuer during the [one] year period preceding the [audit] initiation [date].”95

To implement SOX § 206, the Title II Rules “require that when the lead partner, the concurring partner, or any other member of the audit engagement team who provides more than ten hours of audit, review, or attest services for the issuer accepts a position with the issuer in a financial reporting oversight role within the one year period96 preceding the commencement of audit procedures for the year that included employment by the issuer of the former member of the audit engagement team, the accounting firm is not independent with respect to that issuer.”97 The Title II Rules cover employment in any “financial reporting oversight role,” which would encompass “any individual who has direct responsibility for oversight over those who prepare the [issuer]’s financial statements and related information . . . that are included in [SEC] filings” and is not limited “to the four named positions in SOX § 206 (chief executive officer, controller, chief financial officer and chief accounting officer).”98

F. Prohibited Compensation

The Title II Rules provide that “an accountant is not independent of an audit client if, at any point during the audit and professional engagement period, any audit partner earns or receives compensation based on the audit partner procuring engagements with that audit client to provide any products or services other than audit, review, or attest services.”99 The Title II

94 Id. at 6027 (quoting Warren Buffett, Comments During SEC “Roundtable Discussion on Financial Disclosure

and Auditor Oversight” (Mar. 4, 2002)). 95 SOX § 206, amending 15 U.S.C.A. § 78j-1(l) (West Supp. 2007) [hereinafter SOX § 206]. 96 Title II Release, supra note 31, at 6008 (internal quotations omitted). Under the Title II Rules, the accounting

firm must have completed one annual audit subsequent to when an individual was a member of the audit engagement team before the individual would be eligible for employment by the issuer. Id.

97 Id. at 6032. In the Title II Release, the SEC noted:

While the [employment prohibition] . . . appl[ies] broadly to members of the audit engagement team, [there are] accommodations for certain unique situations. [For example, in a situation where] an individual . . . complied fully with the rule and, subsequent to his or her beginning employment with an issuer, the issuer merged with or was acquired by another entity resulting in he or she becoming a person in a financial reporting oversight role of the combined entity and the combined entity being audited by the individual’s previous employer . . ., unless the employment was taken in contemplation of the combination, . . . [and,] as long as the audit committee is aware of this conflict, the audit firm would continue to be independent under [the Title II Rules].

Id. at 6009. 98 SOX § 206, supra note 95; Title II Release, supra note 31, at 6008. 99 Title II Release, supra note 31, at 6047.


Rules “do[] not preclude an audit partner from sharing in the . . . overall firm [profits].”100 Non-audit partners can be compensated for selling their respective areas of expertise.101 The Title II Release suggests that an audit committee may wish to ascertain the audit firm’s compensation policies regarding senior staff members, as well as partners, when pre-approving non-audit services.102

IV. CORPORATE RESPONSIBILITY (SOX TITLE III)

A. Audit Committees

SOX § 301 requires the SEC to issue rules that will effectively prohibit the listing of an issuer’s stock unless the audit committee complies with certain enhanced requirements that seek to break what is perceived as the direct link between management and the auditors.103 Under SOX § 301, audit committees for listed companies must take charge of the audit, including appointing, compensating, and overseeing the auditors, as well as resolve disputes on accounting matters between auditors and management.104 Although the audit committee must control the audit of a listed company, the financial statements remain the responsibility of management, as evidenced by the required civil certification of all Forms 10-K and 10-Q in SOX § 302 and criminal certification in SOX § 906. Audit committees must also establish procedures to ensure that their members are independent, and they must hear and act on employee complaints regarding questionable accounting or auditing matters. These rules are the complement to the restrictions on registered accounting firms’ activities in SOX § 201, and are considered an important step in ensuring auditor independence and preserving the integrity of the audit process.105

On April 9, 2003, the SEC issued Release No. 33-8220 to implement SOX § 301.106 The SOX § 301 Rule requires that each national stock exchange, including NASDAQ, must adopt rules conditioning the listing of any securities of an issuer upon the issuer being in compliance

100 Id. at 6025. 101 Id. 102 Title II Release supra, note 28 at 6025. 103 SOX § 301, amending 15 U.S.C.A. § 78j-1(m) (West Supp. 2007) [hereinafter SOX § 301]. 104 Id. Under Section 3(a)(58) of the 1934 Act as added by SOX Section 205, the term “audit committee” is

defined as:

(A) A committee (or equivalent body) established by and amongst the board of directors of an issuer for the purpose of overseeing the accounting the financial reporting processes of the issuer and audits of the issuer; and

(B) If no such committee exists with respect to an issuer, the entire board of directors of the issuer. SOX § 205, amending Section 3(a) of the 1934 Act, 15 U.S.C.A. § 78c (West Supp. 2007) (emphasis added). Under this statutory definition of audit committee, the responsibility of the audit committee members is one of “oversight,” not management or doing, of “processes” and “audits.” The audit committee role is one of understanding and monitoring processes and procedures, rather than supervising the preparation of financial statements.

105 See id. 106 Standards Relating to Listed Company Audit Committees, Securities Act Release No. 8220, Exchange Act

Release No. 47,654, Investment Company Act No. 26,001, 68 Fed. Reg. 18,788 (Apr. 16, 2003), available at www.sec.gov/rules/final/33-8220.htm [hereinafter SOX § 301 Release].


with the standards specified in the SOX § 301, which may be summarized as follows:

Oversight—The audit committee must have direct responsibility for the appointment, compensation, and oversight of the work (including the resolution of disagreements between management and the auditors regarding financial reporting) of any registered public accounting firm employed to perform audit services, and the auditors must report directly to the audit committee.107

Independence—The audit committee members must be independent directors, which means that each member may not, other than as compensation for service on the board of directors or any of its committees: (i) accept any consulting, advisory, or other compensation, directly or indirectly, from the issuer or (ii) be an officer or other affiliate of the issuer.108

Procedures to Receive Complaints—The audit committee is responsible for establishing procedures for the receipt, retention, and treatment of complaints regarding accounting, internal accounting controls, or auditing matters, and the confidential, anonymous submission by employees of the issuer (“whistleblowers”) of concerns regarding questionable accounting or auditing matters.109

Funding and Authority—The audit committee must have the authority to hire independent counsel and other advisors to carry out its duties, and the issuer must provide for funding, as the audit committee may determine, for payment of compensation of the issuer’s auditor and of any advisors that the audit committee engages.110

Self-regulatory organizations may adopt additional listing standards regarding audit committees as long as they are consistent with SOX and the SOX § 301 Rule.111

Additional analysis regarding the SOX § 301 Rule follows.

1. Audit Committee Member Independence

To be “independent” and thus eligible to serve on an issuer’s audit committee, audit committee members may not, directly or indirectly accept any consulting, advisory or other compensatory fee from the issuer or a subsidiary of the issuer, other than in the member’s capacity as a member of the board of directors and any board committee.112 This prohibition would preclude payments to a member as an officer or employee, as well as other compensatory payments.113 Indirect acceptance of compensatory payments includes payments to spouses, minor children or stepchildren or children or stepchildren sharing a home with the

107 SOX § 301 Release, supra note 106, at 18,819. 108 See id. 109 Id. 110 Id. Noncompliance would result in delisting, although the SRO rules must provide procedures to permit

issuers an opportunity to cure defects that would otherwise result in delisting. Id. at 18,818. 111 Id. at 18,799. 112 Id. at 18,791. 113 Id.


member as well as payments accepted by an entity in which an audit committee member is a general partner, managing member, executive officer or occupies a similar position and which provides accounting, consulting, legal, investment banking, financial or other advisory services or any similar services to the issuer or any subsidiary.114 Receipt of fixed retirement plan or deferred compensation is not prohibited. Further, a member of the audit committee of an issuer may not be an affiliated person of the issuer or any subsidiary of the issuer apart from his or her capacity as a member of the board and any board committee (subject to the safe harbor described below).115

114 Id. The SOX § 301 Rule restricts only current relationships and does not extend to a “look back” period

before appointment to the audit committee, although SRO rules may do so. SOX § 301, supra note 106. 115 SOX § 301 Release, supra note 106, at 18,793 (internal quotations omitted). In the SOX § 301 Release, the

SEC commented:

[W]e are defining the terms “affiliate” and “affiliated person” consistent with our other definitions of these terms under the securities laws, such as in Exchange Act Rule 12b-2 and Securities Act Rule 144, with an additional safe harbor. We are defining “affiliate” of, or a person “affiliated” with, a specified person, to mean “a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, the person specified.” We are defining the term “control” consistent with our other definitions of this term under the Exchange Act as “the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise.”

. . .

Our definition of “affiliated person” for non-investment companies, like our existing definitions of this term for these issuers, requires a factual determination based on a consideration of all relevant facts and circumstances. To facilitate the analysis on facts and circumstances where we are presumptively comfortable, we are adopting a safe harbor for that aspect of the definition of “affiliated person,” with minor modifications from the original proposal. Under the safe harbor as adopted, a person who is not an executive officer or a shareholder owning 10% or more of any class of voting equity securities of a specified person will be deemed not to control such specified person. . . . We have clarified . . . that the ownership prong should be based on ownership of any class of voting equity securities, instead of any class of equity securities.

. . .

The safe harbor is designed to identify a group of those that are not affiliates so as to provide comfort to those individuals or entities that no additional facts and circumstances analysis is necessary. It only creates a safe harbor position for non-affiliate status. Failing to meet the 10% ownership threshold has no bearing on whether a particular person is an affiliate based on an evaluation of all facts and circumstances. A director who is not an executive officer but beneficially owns more than 10% of the issuer’s voting equity could be determined to be not an affiliate under a facts and circumstances analysis of control.

. . .

[C]alculations of beneficial ownership are to be made consistent with Exchange Act Rule 13d-3.

The proposed rules would have deemed a director, executive officer, partner, member, principal or designee of an affiliate to be an affiliate. . . . Under the final rule, only executive officers, directors that are also employees of an affiliate, general partners and managing members of an affiliate will be deemed to be affiliates. The limitation on directors will exclude outside directors of an affiliate from the automatic designation.

. . .

For issuers that are investment companies, we are adopting, as proposed, the requirement that a member of the audit committee of an investment company may not be an “interested person” of the


Since it is difficult to determine whether someone controls the issuer, the SOX § 301 Rule creates a safe harbor regarding whether someone is an “affiliated person” for purposes of meeting the audit committee independence requirement. Under the safe harbor, a person who is not an executive officer, director, or 10% shareholder of the issuer would be deemed not to control the issuer. A person who is ineligible to rely on the safe harbor, but believes that he or she does not control an issuer, still could rely on a facts and circumstances analysis. This test is similar to the test used for determining insider status under § 16 of the 1934 Act.116

The SEC has authority to exempt from the independence requirements particular relationships with respect to audit committee members, if appropriate in light of the circumstances. Because companies coming to market for the first time may face particular difficulty in recruiting members that meet the proposed independence requirements, the SOX § 301 Rule provides an exception for non-investment company issuers117 which requires only one fully independent member at the time of the effectiveness of an issuer’s initial registration statement under the 1933 Act or the 1934 Act, a majority of independent members within 90 days, and a fully independent audit committee within one year.118

For companies that operate through subsidiaries, the composition of the boards of the parent company and subsidiaries are sometimes similar, given the control structure between the parent and the subsidiaries. If an audit committee member of the parent is otherwise independent, merely serving on the board of a controlled subsidiary should not adversely affect the board member’s independence, assuming that the board member also would be considered independent for purposes of the subsidiary except for the member’s seat on the parent’s board. Therefore, the SOX § 301 Rule exempts from the affiliated person requirement “a committee member that sits on the board of directors of both a parent and a direct or indirect . . . subsidiary [or other affiliate], if the committee member otherwise meets the independence requirements for both the parent and the subsidiary [or affiliate], including the receipt of only [‘]ordinary-course[’] compensation for serving as a member of the board of directors, audit committee[,] or any other board committee of the parent[,] subsidiary[, or affiliate].”119 Any issuer taking advantage of any of the exceptions described above would have to disclose that fact.

2. Responsibilities Relating to Registered Accounting Firms

The SOX § 301 Release states that “[o]ne of the audit committee’s primary functions is to enhance the independence of the audit function, thereby furthering the objectivity of financial reporting.” It is the SEC’s view that the auditing process may be compromised when a company’s outside auditors view their main responsibility as serving the company’s management rather than its full board of directors or its audit committee.

investment company, as defined in Section 2(a)(19) of the Investment Company Act.

SOX § 301 Release, supra note 106, at 18,793–94. 116 17 C.F.R. § 240.12b-2 (2008). 117 SOX § 301 Release, supra note 106, at 18,794. 118 Id. 119 Id. at 18,794–95 (internal quotations omitted).


Therefore, under the SOX § 301 Rule, the audit committee must be directly responsible for the appointment, compensation, retention, and oversight of the work of the independent auditor engaged (including resolution of disagreements between management and the auditor regarding financial reporting) for the purpose of preparing or issuing an audit report or related work or performing other audit, review, or attest services for the issuer, and the independent auditor would have to report directly to the audit committee.120 The oversight responsibilities contemplated include the authority to retain the outside auditor, which would include the power not to retain (or to terminate) the outside auditor.121 The SEC states in the SOX § 301 Release that, “in connection with the[] oversight responsibilities [contemplated], the audit committee [would need to] have ultimate authority to approve all audit engagement fees and terms[, as well as all significant non-audit engagements of the independent auditor].”122 In this regard, the requirement would reinforce the requirement in SOX § 202 that auditing and non-auditing services be pre-approved by the audit committee.123

The requirement will not affect any requirement under a company’s governing law or documents or other home country requirements that require shareholders to elect, approve or ratify the selection of the issuer’s auditor.124 The requirement instead relates to the assignment of responsibility to oversee the auditor’s work as between the audit committee and management. However if, the issuer provides a recommendation or nomination of an auditor to its shareholders, the audit committee of the issuer must be responsible for making the recommendation or nomination.125

3. Procedures for Handling “Whistleblower” Complaints

The SOX § 301 Release states that because “the audit committee is dependent to a degree on the information provided to it by management and internal and outside auditors, it is [important] for the committee to cultivate open and effective channels of information.”126 In order to ensure that these channels remain open, the SOX § 301 Release provides that the “audit committee must establish procedures for:

• The receipt, retention and treatment of complaints received by the issuer regarding accounting, internal accounting controls or auditing matters, and

• The confidential, anonymous submission by employees of the issuer of

120 Id. at 18,796; The SOX Section 301 Release:

propose[s] to exempt investment companies from the requirement that the audit committee be responsible for the selection of the independent auditor . . . [because] . . . [1940] Act [Section 32(a) already] requires that independent auditors of registered investment companies be selected by majority vote of the disinterested directors.

Id. at 18,797. 121 Id. at 18,796. 122 Id. at 18,796. 123 See SOX § 202, supra note 61. 124 SOX § 301 Release, supra note 106, at 18,796. 125 Id. at 18,796–97. 126 Id. at 18,798.


concerns regarding questionable accounting or auditing matters.”127

The SEC has not mandated specific procedures that the audit committee must establish. Each audit committee is encouraged to develop procedures that work best, consistent with its company’s individual circumstances.128

4. Authority to Engage Advisors

The SOX § 301 Release notes that “[t]o perform its role effectively, . . . an audit committee may need the authority to engage its own outside advisors, including experts in particular areas of accounting, as it determines necessary apart from counsel or advisors hired by management, especially when potential conflicts of interest with management may be apparent.”129 The SOX § 301 Rule “specifically requires an issuer’s audit committee to have the authority to engage outside advisors, including counsel, as it determines necessary to carry out its duties.”130

5. Funding

The SOX § 301 Rule: “requires the issuer to provide for appropriate funding, as determined by the audit committee, . . . for payment of compensation:

• To any registered public accounting firm engaged for the purpose of [rendering] or issuing an audit report [or related work] or performing other audit, review or attest services for the listed issuer; and

• To any advisors employed by the audit committee.”131

This rule is designed to prevent the “audit committee’s effectiveness [from] be[ing] compromised [by its] dependen[ce] on management’s discretion to compensate the independent auditor or the advisors employed by the committee, especially when potential conflicts of interest with management may be apparent.”132

6. Trading Markets Affected

SOX § 301 by its terms applies to all stock exchanges and NASDAQ, and, to the extent that their listing standards do not already comply with the rule, they will be required to issue or modify their rules, subject to SEC review, to conform their listing standards.133 The SOX

127 Id.; cf. SOX § 806, infra notes 407–13 and related text. 128 SOX § 301 Release, supra note 106, at 18,798. 129 Id. 130 Id. 131 Id. at 18,798–99. 132 Id. at 18,798. 133 Id. at 18,799; see also New York Stock Exchange and National Association of Securities Dealer Order

Approving Proposed Rule Changes, Exchange Act Release 48,475 (Nov. 4, 2003) available at http://www.sec.gov/rules/sro/34-48475.htm.


§ 301 Rule does not preclude stock exchanges and NASDAQ from adopting additional listing standards regarding audit committees, as long as they are consistent with the SOX § 301 Release.134

The OTC Bulletin Board, the Pink Sheets and the Yellow Sheets will not be affected by the proposed requirements in the SOX § 301 Release.135 Therefore, issuers whose securities are quoted on these interdealer quotation systems similarly would not be affected, unless their securities also are listed on an exchange or NASDAQ.136

7. Issuers and Securities Affected

SOX § 301 “prohibits the listing of ‘any security’ of an issuer that does not meet the new standards for audit committees.”137 Therefore, the SOX § 301 rules apply not just to voting equity securities, but to any listed security, regardless of its type, including debt securities, derivative securities and other types of listed securities.138 The SOX § 301 Rule applies to foreign companies as well as domestic issuers, subject to certain exceptions.139

8. Small Businesses

SOX § 301 makes no distinction based on an issuer’s size, except that small business issuers were given until July 31, 2005, to comply with the new audit committee requirements.140

9. Investment Companies

The SOX § 301 Rule covers closed-end investment companies and exchange-traded, open-end investment companies, but excludes exchange-traded unit investment trusts from the proposed SOX § 301 requirements.141

10. Determining Compliance with Standards

SOX § 301 does not establish specific mechanisms for a national securities exchange or NASDAQ to ensure that issuers comply with the standards on an ongoing basis. SROs are required to comply with SEC rules pertaining to SROs and to enforce their own rules, including rules that govern listing requirements and affect their listed issuers.

The SOX § 301 Release directs the SROs to require a listed issuer to notify the applicable SRO promptly after an executive officer of an issuer becomes aware of any material

134 SOX § 301 Release, supra note 106, at 18,799 135 Id. at 18,800. 136 Id. 137 Id. 138 Id. 139 See infra notes 596–607 and related text. 140 SOX § 301 Release, supra note 106, at 18,790. 141 Id. at 18,797.


noncompliance by the listed issuer with the requirements.142

11. Opportunity to Cure Defects

The SOX § 301 Rule “specifies that [the SRO] rules must provide for appropriate procedures for an issuer to have an opportunity to cure any defects that would be the basis for a prohibition [of the continued listing] of the issuer’s securities as a result of its failure to meet [the SRO] audit committee standards . . . before [the] imposition of such a prohibition.”143 The SRO rules may provide that “an audit committee member [who] ceases to be independent for reasons outside [his] control [may], with notice by the issuer to the [SRO], . . . remain [on the audit committee] until the earlier of [(i)] the next annual meeting [of shareholders] or [(ii) the first anniversary] of the event [which] caused [him not to be] independent.”144

12. Audit Committee Charters

Issuers should review their audit committee charters and amend them to comply with the SOX § 301 Rule and any applicable SRO rules.145

13. Disclosure Changes Regarding Audit Committees

Disclosure Regarding Exemptions—Because exemptions from the rules adopted in the SOX § 301 Release “distinguish certain issuers from most other listed issuers, . . . [the exempted issuers would need to] disclose their reliance on an exemption and their assessment of whether, and if so, how, such reliance [would] materially adversely affect the ability of their audit committee to act independently and to satisfy the other requirements of” the rules.146 Such disclosure would need to appear in, or be incorporated by reference into, (i) annual reports filed with the SEC and (ii) proxy statements or information statements for shareholders’ meetings at which elections for directors are held.147

Identification of the Audit Committee in Annual Reports—Currently, an issuer subject to the SEC proxy rules is required to disclose in its proxy statement or information statement, if action is to be taken with respect to the election of directors, whether the issuer has a standing audit committee, the names of each committee member, the number of committee meetings held by the audit committee during the last fiscal year, and the functions performed by the committee.148 The SOX § 301 Release requires disclosure of the members of the audit committee to be included or incorporated by reference in the listed issuer’s annual report.149 Also, since in the absence of an audit committee the entire board of directors will be considered to be the audit committee, the SEC requires a listed issuer that has not separately

142 Id. at 18,805. 143 Id. at 18,806. 144 Id. 145 Id. at 18,808. 146 Id. at 18,806. 147 Id. 148 Id. at 18,807. 149 Id.


designated or has chosen not to separately designate an audit committee to disclose that the entire board of directors is acting as the issuer’s audit committee.150

Updates to Existing Audit Committee Disclosure—A listed issuer is required to disclose whether the members of its audit committee are independent using the definition of independence for audit committee members included in the applicable listing standards.151 Non-listed issuers that have separately designated audit committees are required to disclose whether their audit committee members are independent, but in determining whether a member is independent, non-listed issuers are allowed to choose any definition for audit committee member independence of a national securities exchange or national securities association that has been approved by the SEC.152

B. CEO/CFO Certifications

SOX contains two separate certification requirements, which are applicable to all public companies, regardless of size, and are in addition to the one-time certification requirement which the SEC imposed on the CEOs and CFOs of the 947 largest public companies pursuant to a June 27, 2002, investigative order.153

1. SOX § 906 Certification

SOX § 906 amended Federal criminal law to require the CEO and CFO to furnish a written certification with each SEC periodic report filed containing financial statements certifying that the financial statements and the disclosures therein fairly present, in all material aspects, the operations and financial condition of the issuer.154 The required form of the SOX § 906 certification follows:155

CERTIFICATION PURSUANT TO 18 U.S.C. § 1350, AS ADOPTED PURSUANT TO § 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the __________ Report of _______________ (the “Company”) on Form 10-__ for the period ending __________ as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, _________________, Chief [Executive] [Financial] Officer of the Company, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that:

150 Id. 151 Id. at 18,808. 152 Id. 153 Order Requiring the Filing of Sworn Statements Pursuant to Section 21(a)(1) of the Securities Exchange Act

of 1934, SEC File No. 4-460 (June 27, 2002), http://www.sec.gov/rules/other/4-460.htm. 154 SOX § 906, 18 U.S.C.A. § 1350 (West Supp. 2007) [hereinafter SOX § 906]; Management’s Report on

Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports, Securities Act Release No. 8238, Exchange Act Release No. 47,986, 68 Fed. Reg. 36,636 (June 18, 2003), available at http://www.sec.gov/rules/final/33-8238.htm.

155 SOX § 906, supra note 154.


(1) The Report fully complies with the requirements of § 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company.

/s/ _______________________________________

_________________________________________ Chief [Executive] [Financial] Officer [Date]

The criminal penalties applicable to a false SOX § 906 certification are (1) 20 years in prison for a willful violation; and (2) ten years for a reckless and knowing violation.156 The § 906 certification requirement was effective July 30, 2002, and was not predicated on any SEC rulemaking.

2. SOX § 302 Certification

The SEC has adopted rules pursuant to SOX § 302 requiring the CEO and CFO of each public company filing a Form 10-Q or 10-K to certify that the financial statements filed with the SEC fairly present, in all material respects, the operations and financial condition of the issuer, as to the adequacy of the issuer’s “disclosure controls and procedures” and “internal controls,” and as to certain other matters.157 The mandated CEO/CFO certification under SOX § 302 is as follows:

I, [identify the certifying individual], certify that:

1. I have reviewed this [specify report] of [identify registrant];

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the

156 Id. 157 SOX § 302, 15 U.S.C.A. § 7241 (West Supp. 2007) [hereinafter SOX § 302]; Securities Act Release No.

8238, supra note 154. Note that certain portions of the Section 302 certification are not mandatory for a particular issuer until the final rules relating to Internal Controls over Financial Reporting are fully in effect for that issuer. See infra notes 333–49 and related text.


financial condition, results of operations and cash flows of the [registrant] as of, and for, the periods presented in this report;

4. The [registrant]’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e))158 [and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f))159]160 for the [registrant] and have:

(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the [registrant], including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

158 For purposes of this certification:

the term “disclosure controls and procedures” [is defined in Rule 13a-15(e) under the 1934 Act as] controls and other procedures of an issuer that are designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the [1934] Act is recorded, processed, summarized[,] and reported . . . within the time periods specified in the [SEC]’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the [1934] Act is accumulated and communicated to the issuer’s management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

17 C.F.R. § 240.13a-15(e) (2008) (emphasis added). 159 For purposes of this certification:

[t]he term “internal control over financial reporting” is defined [in Rule 13a-15(f) and 15d-15(f) under the 1934 Act] as a process designed by, or under the supervision of, the issuer’s principal executive and principal financial officers, or persons performing similar functions, and effected by the issuer’s board of directors, management, and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:

(1) Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the issuer;

(2) Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the issuer are being made only in accordance with authorizations of management and directors of the issuer; and

(3) Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the issuer’s assets that could have a material effect on the financial statements.

17 C.F.R. § 240.13a-15(f) (2008) (emphasis added); see infra notes 333–49 and related text. 160 The bracketed language regarding internal control is not applicable to an issuer until its first Form 10-K that is

required to contain a management report on internal control over financial reporting requirements. Generally, accelerated filers were required to include a management report on internal control over financial reporting requirements in their Forms 10-K for their fiscal years ending on or after November 15, 2004, and all other domestic issuers are required to comply for their Forms 10-K for their fiscal years ending on or after July 15, 2007. See infra notes 333–49 and related text.


(b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c) Evaluated the effectiveness of the [registrant]’s disclosure controls and procedures and presented in this report our conclusion about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d) Disclosed in this report any change in the [registrant]’s internal control over financial reporting that occurred during the [registrant]’s most recent fiscal quarter (the [registrant]’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the [registrant]’s internal control over financial reporting; and161

5. The [registrant]’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the [registrant]’s auditors and the audit committee of the [registrant]’s board of directors (or persons performing the equivalent function):

(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

To implement SOX § 302’s directive that the SOX § 302 certifications be “in” each periodic report, the SEC requires issuers both to (i) file the SOX § 302 certifications as an exhibit to the periodic reports to which they relate162 and (ii) furnish the SOX § 906 “certifications as an exhibit to the periodic reports to which they relate.”163

161 This certification mirrors the requirements in new 1934 Act Rules 13a-15 and 15d-15 which require an issuer

to establish and maintain an overall system of disclosure controls and procedures and internal control over financial reporting that is adequate to meet its 1934 Act reporting obligations. These rules are intended to complement existing requirements for reporting companies to establish and maintain systems of internal controls with respect to their financial reporting obligations. In the SEC’s view, “internal controls” has a meaning which both overlaps and is narrower than “disclosure controls.” See infra notes 333–49 and related text.

162 Securities Act Release No. 8238, supra note 154, at 36,638. 163 Id. In Securities Act Release No. 8238, the SEC noted that SOX § 906 merely requires that the SOX § 906:


3. Enforcement Actions

The SEC is using the SOX certification requirements as an independent basis for enforcement action. In SEC v. Rica Foods, the SEC settled civil injunctive actions against a company headquartered in Costa Rica as well as the officers who personally signed certifications in a Form 10-K Report.164 The predicate of the SEC action was that the officers signed their certifications and filed the Form 10-K Report despite the company’s lack of a signed report of its independent auditors and material classification errors in the financial statements.165 In SEC v. Irving Paul David, the SEC filed an enforcement action against a financial officer of two mutual funds for embezzling funds to which the investment companies were entitled and for filing SOX-mandated certificates that did not disclose his fraud; the U.S. Attorney for the Southern District of New York simultaneously announced an indictment.166

C. CEO/CFO Reimbursement to Issuer

SOX § 304 provides that, if an issuer is required to restate its financial statements owing to noncompliance with securities laws, the CEO and CFO must reimburse the issuer for: (1) any bonus or incentive or equity based compensation received in the 12 months prior to the restatement and (2) any profits realized from the sale of issuer securities within the preceding 12 months.167

The purpose of this provision is to “prevent CEOs and CFOs from making large profits by selling company stock, or receiving company bonuses, while management is misleading the public and regulators about the poor heath of the company.”168 Because there is no relationship between the financial restatement and any misconduct of the CEO or CFO, the CEO and CFO could conceivably be responsible for misconduct of any employee of the issuer. SEC rules are expected to address issues such as: (1) what constitutes “misconduct,” (2) what kinds of restatements trigger this provision, (3) what constitutes material noncompliance with securities laws, and (4) how to measure profits.169

certifications “accompany” [a] periodic report to which they relate[,] . . . in contrast to [SOX §] 302, [that] requires the certifications to be included “in” the periodic report. In recognition of this difference, [the SEC requires issuers] to “furnish,” rather than “file,” the [SOX §] 906 certifications with the [SEC]. Thus, the certifications would not be subject to liability under [1934 Act § 18] . . . [and] would not be subject to automatic incorporation by reference []to a[n issuer]’s [1933] Act registration statements, which are subject to liability under [1933 Act §] 11 . . . , unless the issuer takes steps to include the certifications in a registration statement.

Id. Issuers are to submit the SOX § 906 certifications as exhibits to the periodic reports to which they relate and designate the certifications as an “Additional Exhibit” under Item 99 of Item 601(b) of Regulation S-K. See id.; SOX § 302, supra note 157; SOX § 906, supra note 154.

164 SEC v. Rica Foods., 80 SEC Docket 2735 (Aug. 18, 2003), available at http://www.sec.gov/litigation/litreleases/lr18293.htm.

165 Id. 166 SEC v. David, 80 SEC Docket 2739 (Aug. 1, 2003), available at

http://www.sec.gov/litigation/litreleases/lr18300.htm. 167 SOX § 304, 15 U.S.C.A. § 7243 (West Supp. 2007) [hereinafter SOX § 304]. 168 S. REP. NO. 107-205, at 26 (2002). 169 Id. In Neer v. Pelino, the court held that the disgorgement is limited to SEC action and that no new private


D. D&O Bars

SOX § 305 authorizes a court to prohibit a violator of certain SEC rules from serving as an officer or director of an issuer if the person’s conduct demonstrates unfitness to serve (the pre-SOX standard was “substantial unfitness”).170

E. Insider Trading Freeze During Plan Blackout

SOX § 306 prohibits “any director or executive officer of an issuer of any equity security [from], directly or indirectly, . . . purchas[ing], sell[ing], or otherwise acquir[ing] or transfer[ring] any equity security of the issuer . . . during [a pension plan] blackout period” that temporarily prevents plan participants or beneficiaries from engaging in equity securities transactions through their plan accounts, “if [the] director or [executive] officer acquire[d the] equity security in connection with his or her service or employment as a director or executive officer.”171 Under SOX § 306, “profits realized [from such trades] shall inure to and be recoverable by the issuer . . . irrespective of [the] intent[]” of the parties to the transaction.172

The Enron scandal provided impetus for SOX § 306(a) when insiders were able to liquidate their Enron stock before its price plunged, even as employees were stuck holding shares during a pension blackout period, resulting in often devastating losses in their accounts.173 SOX § 306(a) restrictions on transactions by insiders would apply to all reporting companies, including foreign private issuers, banks and savings associations, and small

cause of action was created by SOX § 304. 389 F. Supp. 2d 648 (E.D. Pa. 2005). The SEC’s first settlement in the context of a SOX § 304 enforcement action was with William W. McGuire, M.D., former CEO and Chairman of the Board of UnitedHealth Group, Inc. Former United Health Group CEO/Chairman Settles Stock Options Backdating Case for $468 Million, SEC Litigation Release No. 20387 (Dec. 6, 2007). The SEC alleged that Dr. McGuire “caused the company to grant undisclosed, in-the-money stock options to himself and other UnitedHealth officers and employees without recording in the company’s books and disclosing to shareholders material amounts of compensation expenses as required by applicable accounting rules.” Id. Dr. McGuire, without admitting or denying the SEC’s allegations, consented to a $468 million settlement. In SEC v. Shanahan, the court granted partial summary judgment for the defendant, former Engineered Support Systems, Inc. CEO Michael F. Shanahan Sr., regarding the SEC’s SOX § 304 cause of action. No. 4:07CV270, 2008 WL 5211909, (E.D. Mo. Dec. 12, 2008). In granting the partial summary judgment, the court held that “an issuer must be compelled or ordered to prepare a financial restatement, and must actually file the restatement” before the reimbursement obligations of SOX § 304 are triggered. Id. at *5. Since the SEC never required the defendant’s company to restate the financial statements in question, the court held that SOX § 404 did not apply to the defendant. The court pointed to the legislative history of SOX § 404 in support of its position: “legislative history indicates Congress contemplated [SOX § 404’s] applicability only in terms of ‘accounting restatements that result from material non-compliance,’ rather than cases where there should have been an accounting restatement because of material non-compliance.” Id. (citing S. REP. NO. 107-205, at 53 (2002)). Therefore, under the court’s interpretation, SOX § 404 is not applicable unless: (i) the SEC either compels or orders a financial restatement, and (ii) the financial restatement is actually filed.

170 SOX § 305, modifying 15 U.S.C.A. § 78u. (West Supp. 2007). 171 SOX § 306 (a)(1), 15 U.S.C.A. § 7244(a)(1) (West Supp. 2007) [hereinafter SOX § 306]. 172 Id. at (a)(2)(A). 173 Thomas O. Gorman & Heather J. Stewart, Is There a New Sheriff in Corporateville? The Obligations of

Directors, Officers, Accountants, and Lawyers After Sarbanes-Oxley of 2002, 56 ADMIN. L. REV. 135, 150 (2004).


business issuers.174 The SEC was required to adopt implementing rules within 180 days of the effective date of SOX (January 26, 2003).175

1. Regulation BTR

On January 22, 2003, the SEC adopted Regulation Blackout Trading Restriction (“Regulation BTR”) to implement SOX § 306(a) “and to prevent evasion of the statutory trading prohibition.”176 Regulation BTR “incorporat[es] a number of concepts developed under [1934 Act §] 16 . . . to take advantage of a well-established body of rules and interpretations concerning the trading activities of corporate insiders and, as to directors and executive officers of domestic issuers, facilitate enforcement of the § 306(a) trading prohibition through monitoring of the reports publicly filed by directors and executive officers pursuant to [1934 Act §] 16(a).”177

2. Persons Subject to Trading Prohibition

SOX § 306(a) and Regulation BTR apply to the directors178 and executive officers179 of domestic issuers, foreign companies,180 small business issuers181 and, in rare instances, registered investment companies.182

174 S. REP. NO. 107-205, at 27 (2002). 175 SOX § 208, 15 U.S.C.A. § 7233 (West Supp. 2007). 176 Insider Trades During Pension Fund Blackout Periods, Exchange Act Release No. 47,225, Investment

Company Act Release No. 25,909, 68 Fed. Reg. 4338, 4338 (Jan. 28, 2003), available at http://www.sec.gov/rules/final/34-47225.htm.

177 Id. at 4339. 178 Under Regulation BTR, the term “director” has the meaning set forth in 1934 Act §3(a)(7). Id. at 4339. As

the SEC has previously noted, this definition reflects a “functional and flexible” approach to determining whether a person is a director of an entity. Improper Influence on Conduct of Audits, Exchange Act Release No. 47,890, Investment Company Act Release No. 26,050, 80 SEC Docket 770 (May. 20, 2003), available at http://www.sec.gov/rules/final/34-47890.htm.

Thus, for purposes of [SOX] Section 306(a) . . . and Regulation BTR, an individual’s title is not dispositive as to whether he or she is a director. As under [1934 Act] Section 16 . . ., attention must be given to the individual’s underlying responsibilities or privileges with respect to the issuer and whether he or she has a significant policy-making role with the issuer.

Exchange Act Release No. 47,225, supra note 176, at 4340 (citing Ownership Reports and Trading by Officers, Directors and Principal Security Holders, Exchange Act Release No. 28,869, Investment Company Act Release No. 17,991, 56 Fed. Reg. 7242, at § II.A.1 (Feb. 21, 1991)). “An individual may hold the title “director” and yet, because he or she is not acting as such, not be deemed a director.” Id. at 4340 (citing Ownership Reports and Trading by Officers, Directors and Principal Stockholders, Exchange Act Release No. 26,333, Investment Company Act Release No. 16,669, 53 Fed. Reg. 49,997, at § III.A.2 (Dec. 13, 1988)).

179 Under Regulation BTR, the term “executive officer” has the same meaning as the term “officer” in 1934 Act Rule 16a-1(f). Exchange Act Release No. 47,225, supra note 176, at 4356.

180 See infra notes 612–15 and related text. 181 SOX Section 306(a) does not distinguish between large and small issuers. SOX § 306, supra note 171. 182 Exchange Act Release No. 47,225, supra note 176, at 4339.


3. Securities Subject to Trading Prohibition

SOX § 306(a) applies to any equity security of an issuer other than an exempt security.183

4. Transactions Subject to Trading Prohibition

SOX § 306(a) is interpreted to make it “unlawful . . . for [a] director or executive officer of an issuer of any equity security . . . , directly or indirectly, to purchase, sell[,] or otherwise acquire or transfer any equity security of the issuer . . . during [a pension plan] blackout period with respect to [the] equity security . . . if [the] director or executive officer acquire[d] . . . such equity security in connection with his or her service or employment as a director or executive officer.”184

a. Acquired in Connection with Service or Employment as a Director or Executive Officer

Regulation BTR defines the phrase “acquired such equity security in connection with service or employment as a director or executive officer” to include equity securities acquired by a director or executive officer:

• At a time when he or she was a director or executive officer under a compensatory plan, contract, authorization, or arrangement, including, but not limited to, plans relating to options, warrants or rights, pension, retirement or deferred compensation or bonus, incentive or profit-sharing (whether or not set forth in any formal plan document), including a compensatory plan, contract, authorization, or arrangement with a parent, subsidiary or affiliate;185

183 SOX § 306(a), supra note 171. Rule 100(i) of Regulation BTR defines the term “exempt security” by

reference to the definition in 1934 Act Section 3(a)(12). 17 C.F.R. § 245.100(i) (2008). Rule 100(f) provides that the term “equity security of the issuer” includes any equity security or derivative security relating to an issuer, whether or not issued by that issuer. 17 C.F.R. § 245.100(f) (2006). Rule 100(d) provides that the term “derivative security” has the same meaning as in 1934 Act Rule 16a-1(c), which defines the term “derivative securities” to mean:

any option, warrant, convertible security, stock appreciation right, or similar right with an exercise or conversion privilege at a price related to an equity security, or similar securities with a value derived from the value of an equity security, but shall not include: (1) Rights of a pledgee of securities to sell the pledged securities; (2) Rights of all holders of a class of securities of an issuer to receive securities pro rata, or obligations to dispose of securities, as a result of a merger, exchange offer, or consolidation involving the issuer of the securities; (3) Rights or obligations to surrender a security, or have a security withheld, upon the receipt or exercise of a derivative security or the receipt or vesting of equity securities, in order to satisfy the exercise price or the tax withholding consequences of receipt, exercise or vesting; (4) Interests in broad-based index options, broad-based index futures, and broad-based publicly traded market baskets of stocks approved for trading by the appropriate federal governmental authority; (5) Interests or rights to participate in employee benefit plans of the issuer; (6) Rights with an exercise or conversion privilege at a price that is not fixed; or (7) Options granted to an underwriter in a registered public offering for the purpose of satisfying over-allotments in such offering.

17 C.F.R. § 240.16a–1(c) (2008). 184 17 C.F.R. § 245.101(a) (2008). 185 17 C.F.R. § 245.100(a)(1) (2008).


• At a time when he or she was a director or executive officer as a result of any transaction or business relationship described in paragraph (a) [or (b)] of Item 404 of Regulation S-K186 to the extent that he or she has a pecuniary interest in the equity securities;187

• At a time when he or she was a director or executive officer, as “directors’ qualifying shares” or other securities that he or she must hold to satisfy minimum ownership requirements or guidelines for directors or executive officers;188

• Prior to becoming, or while, a director or executive officer where the equity security was acquired as a direct or indirect inducement to service or employment as a director or executive officer;189 or

• Prior to becoming, or while, a director or executive officer where the equity security was received as a result of a business combination in respect of an equity security of an entity involved in the business combination that he or she had acquired in connection with service or employment as a director or executive officer of such entity.190

b. Service or Employment Presumption

Regulation BTR provides that any equity securities sold or otherwise transferred during a blackout period by a director or executive officer of an issuer will be considered to have been “acquired in connection with service or employment as a director or executive officer” to the extent that the director or executive officer had a pecuniary interest in such securities at the time of the transaction, unless he or she establishes that the equity securities were not “acquired in connection with service or employment as a director or executive officer.”191 To establish this defense, a director or executive officer must specifically identify the origin of the equity securities in question and demonstrate that this identification of the equity securities is consistent for all purposes related to the transaction (such as tax reporting and any applicable disclosure and reporting requirements).192 In other words, to the extent that directors and executive officers are able to specifically identify, or trace, the source of equity securities sold or otherwise transferred during a blackout period, the transaction will not be considered to involve securities “acquired in connection with service or employment as a director or executive officer.”193

186 17 C.F.R. § 229.404 (2006). 187 17 C.F.R. § 245.100(a)(2) (2008). 188 17 C.F.R. § 245.100(a)(3) (2008). 189 17 C.F.R. § 245.100(a)(4) (2008). 190 17 C.F.R. § 245.100(a)(5) (2008). 191 17 C.F.R. § 245.101(b) (2008). 192 Id. 193 Id.


c. Transitional Situations

Equity securities acquired by an individual before he or she becomes a director or executive officer are not “acquired in connection with service or employment as a director or executive officer.”194 Thus, equity securities acquired under a compensatory plan, contract, authorization, or arrangement while an individual is an employee, but not a director or executive officer, will not be subject to the SOX § 306(a) trading prohibition. However, equity securities acquired by an employee before becoming a director or executive officer will be considered “acquired in connection with service or employment as a director or executive officer” if the equity securities are part of an inducement award.195

In contrast, equity securities acquired by an individual in connection with service or employment as a director or executive officer before an entity becomes an issuer are considered “acquired in connection with service or employment as a director or executive officer” for purposes of SOX § 306(a) and Regulation BTR and are subject to the statutory trading prohibition.196 Similarly, equity securities acquired by a director or executive officer in connection with his or her service or employment as a director or executive officer of an issuer before the effective date of SOX § 306(a) are subject to that section and Regulation BTR.197

d. Exempt Transactions

Regulation BTR exempts from the statutory trading prohibition:

• acquisitions of equity securities under dividend or interest reinvestment plans;198

• purchases or sales of equity securities pursuant to a trading arrangement that satisfies the affirmative defense conditions of [1934 Act] Rule 10b5-1(c);199

• purchases or sales of equity securities, other than discretionary transactions, pursuant to certain tax-conditioned plans;200

• increases or decreases in the number of equity securities held as a result of a stock split or stock dividend applying equally to all equity securities of that class;201

194 17 C.F.R. § 245.100(a) (2008) (internal quotations omitted). 195 17 C.F.R. § 245.100(a)(4) (2008) (internal quotations omitted). 196 17 C.F.R. § 245.100(a) (2008) (internal quotations omitted). 197 Exchange Act Release 47,225, supra note 176, at 4342; 17 C.F.R. § 245.100(a) (2006) (internal citations

omitted). 198 17 C.F.R. § 245.101(c)(1) (2008). 199 17 C.F.R. § 245.101(c)(2) (2008). 200 17 C.F.R. § 245.101(c)(3) (2008) (internal quotations omitted). 201 17 C.F.R. § 245.101(c)(10) (2008).


• compensatory grants and awards of equity securities (including options and stock appreciation rights) pursuant to a plan that, by its terms, permits directors or executive officers to receive grants or awards, provides for grants or awards to occur automatically, and specifies the terms and conditions of the grants or awards;202

• exercises, conversions, or terminations of derivative securities that were not written or acquired by a director or executive officer during the blackout period in question or while aware of the actual or approximate beginning or ending dates of the blackout period, and where (i) the derivative security, by its terms, may be exercised, converted, or terminated only on a fixed date, with no discretionary provision for earlier exercise, conversion, or termination, or (ii) the derivative security is exercised, converted, or terminated by a counterparty and the director or executive officer does not exercise any influence on the counterparty with respect to whether or when to exercise, convert, or terminate the derivative security;203

• acquisitions or dispositions of equity securities involving a bona fide gift or a transfer by will or the laws of descent and distribution;204

• acquisitions or dispositions of equity securities pursuant to a domestic relations order;205

• sales or other dispositions of equity securities compelled by the laws or other requirements of an applicable jurisdiction;206 and

• acquisitions or dispositions of equity securities in connection with a merger, acquisition, divestiture[,] or similar transaction occurring by operation of law.207

The exemption in Regulation BTR does not extend to “discretionary transactions,” such as an intra-plan transfer involving an issuer equity securities fund or a cash distribution funded by a volitional disposition of an issuer equity security,208 that occur during a blackout period.209 However, it would cover acquisitions or dispositions of equity securities made in connection with death, disability, retirement or termination of employment, or transactions involving a

202 17 C.F.R. § 245.101(c)(4) (2008). 203 17 C.F.R. § 245.101(c)(5) (2008). 204 17 C.F.R. § 245.101(c)(6) (2008). 205 17 C.F.R. § 245.101(c)(7) (2008). 206 17 C.F.R. § 245.101(c)(8) (2008). 207 Exchange Act Release No. 47,225, supra note 176, at 4342–44; 17 C.F.R. § 245.101(c)(9) (2008). 208 17 C.F.R. § 240.16b–3(b)(4) (2008) (internal quotations omitted). 209 17 C.F.R. § 245.101(c)(3) (2008).


diversification or distribution required by the Internal Revenue Code to be made available to plan participants because these transactions are not “discretionary transactions.”210

5. Blackout Period

SOX § 306(a)(4)(A) defines the term “blackout period” to mean any period of more than three consecutive business days during which the ability of not fewer than 50% of the participants or beneficiaries under all “individual account plans” maintained by an issuer to purchase, sell, or otherwise acquire or transfer an interest in any equity security of the issuer held in such an individual account plan is temporarily suspended by the issuer or by a fiduciary of the plan.211

a. Individual Account Plan

The Regulation BTR definition of “individual account plan” “encompasses a variety of pension plans, including 401(k) plans, profit-sharing and savings plans, stock bonus plans, and money purchase pension plans, but excludes one-participant retirement plans and pension plans, in which participation is limited to directors of the issuer.212

b. Blackout Period

Regulation BTR defines “blackout period” such that, “in determining whether a temporary trading suspension in issuer equity securities constitutes a ‘blackout period,’ the individual account plans to be considered are individual account plans maintained by an issuer that permit participants or beneficiaries located in the United States to acquire or hold equity securities of the issuer.”213

c. Determining Participants and Beneficiaries

“Once an issuer has identified the relevant individual account plans, it must determine whether the temporary suspension of trading in its equity securities affects 50% or more of the participants or beneficiaries under these plans.214 This is accomplished by comparing the number of participants or beneficiaries located in the United States who are subject to the temporary trading suspension in issuer equity securities to the number of participants or beneficiaries located in the United States under all individual account plans maintained by the issuer.”215 “In the case of a domestic issuer, where this percentage is 50% or more[,] the temporary trading suspension constitutes a ‘blackout period,’ so . . . the [SOX §] 306(a)

210 Exchange Act Release No. 47,225, supra note 176, at 4343 (internal quotations omitted); 17 C.F.R.

§ 240.16b–3(b)(4) (2008). 211 Exchange Act Release No. 47,225, supra note 176, at 4344 (emphasis added); SOX § 306(a)(4)(A), supra

note 171. 212 Exchange Act Release No. 47,225, supra note 176, at 4345; 17 C.F.R. § 245.100(j) (2008). 213 Exchange Act Release No. 47,225, supra note 176, at 4345 (emphasis added); 17 C.F.R. § 245.100(b)(1)

(2008). 214 17 C.F.R. § 245.100(b)(1) (2008). 215 Id.


trading prohibition applies to the issuer’s directors and executive officers.”216

“On any [given] day, it may be difficult for an issuer to know precisely how many participants and beneficiaries are . . . covered by all of its individual account plans. As a result, issuers will need to apply the ‘50% test’ on the basis of estimates.”217 Regulation BTR contains provisions for making reasonable estimates.218

d. Exceptions to Definition of Blackout Period

SOX § 306(a)(4)(B) expressly excludes from the definition of the term “blackout period” two types of temporary trading suspensions:

• “A regularly scheduled period in which the participants and beneficiaries may not purchase, sell[,] or otherwise acquire or transfer an interest in any equity security of an issuer, if such period is—

o Incorporated into the individual account plan; and

o Timely disclosed to employees before they become participants under the individual account plan or as a subsequent amendment to the plan;219 [or]

• Any temporary trading suspension that would otherwise be a ‘blackout period’ that is imposed solely in connection with persons becoming participants or beneficiaries, or ceasing to be participants or beneficiaries, in an individual account plan by reason of a corporate merger, acquisition, divestiture[,] or similar transaction involving the plan or plan sponsor.”220

216 With respect to foreign private issuers, see infra notes 612–15 and related text. 217 Exchange Act Release 47,225 supra note 176 at 4345–46. 218 Id. at 4346. 219 Regulation BTR:

provides that the requirement that the regularly scheduled period be incorporated into the individual account plan may be satisfied by including a description of the regularly scheduled trading suspension in issuer equity securities, including the suspension’s frequency and duration and the plan transactions to be suspended or otherwise affected, in either the official plan documents or other documents or instruments that govern plan operations. In the latter case, these documents or instruments may include an ERISA Section 404(c) notice or an advance notice in either the plan’s summary plan description or any other official plan communication.

Id. at 4347. The:

disclosure of the regularly scheduled trading suspension will be considered timely if the employee is notified of the trading suspension at any time prior to, or within 30 calendar days after, the employee’s formal enrollment in the plan, or, in the case of a subsequent amendment to the plan, within 30 calendar days after adoption of the amendment.

Id. at 4347–48. 220 Id. at 4347; 17 C.F.R. § 245.102 (2008).


6. Remedies

SOX § 306(a) “contains two distinct sets of remedies[: (i) a] violation of the statutory trading prohibition in [SOX §] 306(a)(1) is treated as a violation of the [1934] Act and subject to all resulting sanctions, including [SEC] enforcement action[, and (ii)] where a director or executive officer realizes a profit from a prohibited transaction during a blackout period, [SOX §] 306(a)(2) permits an issuer, or a security holder of the issuer on its behalf, to bring an action to recover that profit.”221

“Under the latter provision, an issuer, or a security holder on its behalf, may initiate an action only if a director or executive officer realized a profit as a result of a prohibited purchase, sale or other acquisition[,] or transfer of an equity security during a blackout period.222 As under [1934 Act §] 16(b), this concept of ‘realized profits’ means that the director or executive officer [must have] received a direct or indirect pecuniary benefit from the transaction.”223

“To provide guidance to the courts [regarding SOX §] 306(a)(2) private actions against directors and executive officers who have violated the statutory trading prohibition, . . . Regulation BTR provides that [w]here a transaction involves a purchase, sale or other acquisition[,] or transfer . . . of a [listed] equity security [(other than a grant, exercise, conversion, or termination of a derivative security)], profit is to be measured by comparing the difference between the amount paid or received for the equity security on the date of the transaction during the blackout period and the average market price of the equity security calculated over the first three trading days after the ending date of the blackout period.”224 Otherwise, “profit is to be measured in a manner that is consistent with the objective of identifying the amount of any gain realized or loss avoided as a result of the transaction taking place during the blackout period rather than taking place outside of the blackout period.”225

“To mitigate the effect of large fluctuations in the market price of an issuer’s equity securities after a blackout period and deter attempts to manipulate this market price, . . . Regulation BTR uses a three-day average trading price to determine the amount that a director

Note:

[i]n the case of a temporary trading suspension in issuer equity securities imposed in connection with a merger, acquisition, divestiture[,] or similar transaction, . . . Regulation BTR provides that the temporary suspension will not constitute a “blackout period” for purposes of [SOX] Section 306(a) if[: (i)] its principal purpose is to enable individuals to become participants or beneficiaries in an individual account plan by reason of the transaction, or to terminate participation in the plan, even though the suspension [is] also . . . used to effect other administrative actions that are incidental to the admission or withdrawal of plan participants or beneficiaries . . ., [and (ii)] the persons becoming participants or beneficiaries are not permitted to participate in the same class of equity securities after the merger, acquisition, divestiture[,] or similar transaction as before the transaction.

Exchange Act Release No. 47,225, supra note 176, at 4348. 221 SOX § 306(a)(1)–(2), supra note 171. 222 SOX § 306(a)(2)(A), supra note 171. 223 Exchange Act Release No. 47,225, supra note 176, at 4348; 17 C.F.R. § 240.16a-1(a)(2) (2008). 224 Exchange Act Release No. 47,225, supra note 176, at 4357. 225 Id.


or executive officer would have paid or received if the transaction had occurred after the end of the blackout period.226

7. Notice of Blackout Period

SOX § 306(a)(6) requires that an issuer provide timely notice to its directors and executive officers227 and to the SEC on Form 8-K of the imposition of a blackout period that triggers the trading prohibition of SOX § 306(a).228

V. ENHANCED FINANCIAL DISCLOSURES; PROHIBITION ON INSIDER LOANS (SOX TITLE IV)

A. Off-Balance Sheet Transactions; Use of Non-GAAP Financial Measures

SOX § 401 instructs the SEC to require by rule: (1) Form 10-K and 10-Q “disclos[ure of]

226 Id. at 4349. 227 Id. at 4349; SOX § 306(a)(6), supra note 171.

Regulation BTR requires that the notice specify the length of the blackout period[,] . . . [using either] the actual or expected beginning [date] and ending date[] of the blackout period, . . . or the calendar week or weeks during which the blackout period is expected to begin and end, provided that during such week or weeks information as to whether the blackout period has begun or ended is readily available . . . without charge [(such as via a toll-free telephone number or access to a specified web site)] to affected directors and executive officers[,] . . . and [that] the notice describes how to access the information. [Regulation BTR] further permits the length of the blackout period to be described in the notice to the [SEC] using the calendar week or weeks during which the blackout period is expected to begin and end, provided that the notice also describes how a security holder or other interested person may obtain, without charge, the actual beginning and ending dates of the blackout period. Under the rule, it is permissible to use a “week of _____” beginning date and a “week of _____” ending date. It also is permissible to use a specific beginning date and a “week of _____” ending date, or the converse. For purposes of the rule, a calendar week is defined to mean a seven-day period beginning on Sunday and ending on Saturday. . . . [I]f an issuer elects to provide the actual or expected beginning and ending dates of a blackout period in the required notice, and either or both of those dates change, the issuer is required to provide directors and executive officers and the [SEC] with an updated notice identifying the change [in] date or dates, explaining the reasons for the change[s] . . . and identifying all material changes in the information contained in the prior notice. The updated notice is required to be provided as soon as reasonably practicable.

Exchange Act Release 47,225, supra note 176, at 4349–50; See Filing Guidance Related to: Conditions for Use of Non-GAAP Financial Measures; and Insider Trades During Pension Fund Blackout Periods, Securities Act Release No. 8216, Exchange Act Release No. 47,583, Investment Company Act Release No. 25,983, 68 Fed. Reg. 15,939 (Apr. 2, 2003), available at http://www.sec.gov/rules/final/33-8216.htm.

Regulation BTR provides that the notice to directors and executive officers will be considered timely if an issuer provides it no later than five business days after the issuer receives the notice from the pension plan administrator as required by the [Department of Labor] Rules. If the issuer does not receive such notice, the issuer must provide its notice to directors and executive officers at least 15 calendar days before the actual or expected beginning date of the blackout period. This [provision is designed to] ensure that an issuer [will] typically . . . not be required to provide the notice . . . [under SOX] Section 306(a)(6) to its directors and executive officers until it has received notice of an impending blackout period from the pension plan administrator. Notwithstanding this general requirement, . . . Regulation BTR provides that advance notice is not required in any case where . . . unforeseeable event[s] or circumstances beyond the issuer’s reasonable control prevent the issuer from providing advance notice to its directors and executive officers.

Exchange Act Release 47,225, supra note 176, at 4350. 228 Id. at 4349; SOX § 306(a)(6), supra note 171.


all material off-balance sheet transactions [and relationships] . . . with unconsolidated entities . . . that may have a material . . . effect [up]on” the financial status of an issuer,229 and (2) presentation of pro forma financial information in a manner that is not misleading, and which is reconcilable with the financial condition of the issuer under generally accepted accounting principles.230 Also under SOX § 401, “[e]ach financial report . . . [must] [“]reflect[”] all material . . . adjustments” proposed by the auditors, which we interpret to mean all material suggested auditor adjustments must be disclosed in the 10-K or 10-Q, either through incorporation into the issuer’s financial presentation or in a separate discussion explaining why the adjustment was not made.231

1. MD&A Disclosures

On January 27, 2003, the SEC issued Release No. 33-8182 titled “Disclosure in Management’s Discussion and Analysis About Off-Balance Sheet Arrangements and Aggregate Contractual Obligations.”232 In the release, the SEC states that: “[t]he principle [behind the new rules] is that the [issuer] should disclose information to the extent that it is necessary to [reach] an understanding of a[n issuer]’s material off-balance sheet arrangements and their material effects on financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources.233 Consistent with [the] traditional . . . [principles applicable to the ‘Management’s Discussion and Analysis of Financial Condition and Results of Operations’ (“MD&A”) section in a company’s disclosure documents], management has the responsibility to identify and address the key variables and other qualitative and quantitative factors that are peculiar to, and necessary for, an understanding and evaluation of the company.”234

In the SEC’s view, as codified by the adopted rules “[t]hese items require disclosure of the following information to the extent necessary for an understanding of a[n issuer]’s off-balance sheet arrangements and their effects:

• The nature and business purpose of the [issuer]’s off-balance sheet arrangements;

• The importance of the off-balance sheet arrangements to the [issuer] for liquidity, capital resources, market risk or credit risk support[,] or other benefits;

• The financial impact of the arrangements on the [issuer] (e.g., revenues,

229 SOX § 401(a), amending 15 U.S.C.A. § 78m (West Supp. 2007) [hereinafter SOX § 401]. 230 Id. 231 Id. 232 Disclosure in Management’s Discussion and Analysis About Off-Balance Sheet Arrangements and Aggregate

Contractual Obligations, Securities Act Release No. 8182, Exchange Act Release No. 47,264, 68 Fed. Reg. 5982, 5992 (Feb. 5, 2003), available at http://www.sec.gov/rules/final/33-8182.htm.

233 Id. at 5985. 234 Id.


expenses, cash flows or securities issued) and the [issuer]’s exposure to risk as a result of the arrangements (e.g., retained interests or contingent liabilities); and

• Known events, demands, commitments, trends or uncertainties that affect the availability or benefits to the [issuer] of material off-balance sheet arrangements.”235

“In addition, the [rules] contain another principles-based requirement, similar to that used elsewhere in MD&A, that the [issuer] provide other information that it believes to be necessary for an understanding of its off-balance sheet arrangements and their material effects on the [issuer]’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.”236

“The [rule] require[s] a[n issuer] to provide[,] . . . in a separately captioned subsection of [MD&A,] a [comprehensive] explanation of its off-balance sheet arrangements.”237

“The [rule] also require[s an issuer] . . . to provide an overview of [its aggregate] contractual obligations in a tabular format” in the MD&A.238

“[T]he following categories of contractual obligations must be included within the table:

• Long-term debt obligations;

• Capital lease obligations;

• Operating lease obligations;

• Purchase obligations; and

• Other long-term liabilities reflected on the issuer’s balance sheet under GAAP.”239

“The [rules] require disclosure of the amounts of a[n issuer]’s purchase obligations without regard to whether notes, drafts, acceptances, bills of exchange[,] or other commercial instruments will be used to satisfy such obligations because those instruments could have a significant effect on the [issuer]’s liquidity.240 The [SEC’s] purpose [in requiring] this new disclosure [item] is to obtain enhanced disclosure concerning a[n issuer]’s contractual payment

235 Id. 236 Id. 237 Id. at 5991. 238 Id. at 5983. 239 Id. at 5986. 240 Id.


obligations. . . .”241

Issuers “must comply with the off-balance sheet arrangement disclosure requirements in registration statements, annual reports[,] and proxy or information statements that are required to include financial statements for their fiscal years ending on or after June 15, 2003.”242 Issuers “must include the table of contractual obligations in registration statements, annual reports, and proxy or information statements that are required to include financial statements for the fiscal years ending on or after December 15, 2003.”243

2. Conditions for Use of Non-GAAP Financial Measures: Regulation G

On January 22, 2003, the SEC issued Release No. 33-8176 titled “Conditions for Use of Non-GAAP Financial Measures,” adopting rule changes designed to address reporting companies’ use of “non-GAAP financial measures” in various situations, including (i) Regulation G which applies whenever a reporting company publicly discloses or releases material information that includes a non-GAAP financial measure; (ii) amendments to Item 10 of Regulation S-K to include a statement concerning the use of non-GAAP financial measures in filings with the SEC; and (iii) amendments to Form 8-K to require issuers to furnish to the SEC all releases or announcements disclosing material non-public financial information about completed annual or quarterly periods.244

Regulation G applies whenever, as of and after March 28, 2003,245 an issuer246 publicly discloses or releases material information that includes a non-GAAP financial measure.247 Regulation G contains an exception for “non-GAAP financial measure[s] included in [a]

241 Id. 242 Id. at 5991. 243 Id. 244 Conditions for Use of Non-GAAP Financial Measures, Securities Act Release No. 8176, Exchange Act

Release No. 47,226, 68 Fed. Reg. 4820 (Jan. 30, 2003), available at http://www.sec.gov/rules/final/33-8176.htm. 245 With regard to transition issues, the SEC discussed a case in which a report was filed with the Commission

before the rule’s effective date of March 28, 2003, and then was incorporated by reference into a registration statement that was filed after March 28, 2003, and the staff concluded that the registration statement must comply with Regulation G with respect to any non-GAAP financial measures. With regard to any non-GAAP material incorporated by reference, the staff advised that companies may provide the required reconciliation by:

(i) amend[ing] the previously filed report . . .; (ii) includ[ing] a section []in the . . . registration statement that identifies the non-GAAP financial measures . . . contained in the incorporated reports and provides the required reconciliation[s]; or (iii) fil[ing] a current report on Form 8-K or a periodic report that identifies the non-GAAP financial measures . . . in the incorporated reports and provides the required reconciliation[s]. . . .

[A] registration statement on Form S-8 filed after March 28, 2003, does not [have to] include the required reconciliation of non-GAAP financial measures included in a document filed before [that date] and incorporated by reference.

U.S. Securities Exchange Commission Frequently Asked Questions Regarding the Use of Non-GAAP Financial Measures, Transition Issues, Question 1 (June 13, 2003), http://www.sec.gov/divisions/corpfin/faqs/nongaapfaq.htm.

246 See infra notes 636–39 and related text with respect to the application of Regulation G to issuers that are foreign private issuers.

247 Securities Act Release No. 8176, supra note 244, at 4821.


disclosure relating to a proposed business combination [transaction] . . . if the disclosure is contained in a communication that is subject to the [SEC’s] communications rules applicable to business combination transactions.”248

For purposes of Regulation G, a non-GAAP financial measure is a numerical measure of an issuer’s historical or future financial performance, financial position, or cash flows that:

• excludes amounts, or is subject to adjustments that have the effect of excluding amounts, that are included in the most directly comparable measure calculated and presented in accordance with GAAP in the statement of income, balance sheet, or statement of cash flows (or equivalent statements) of the issuer; or

• includes amounts, or is subject to adjustments that have the effect of including amounts, that are excluded from the most directly comparable measure so calculated and presented.249

The definition of “non-GAAP financial measures” does not capture measures of operating performance or statistical measures that fall outside the scope of the definition set forth above, such as:

• operating and other statistical measures (such as unit sales, numbers of

248 Id. In a response to a “Frequently Asked Questions” dated June 13, 2003, the SEC discussed whether the

exemption from Regulation G and Item 10(e) of Regulation S-K for disclosure of non-GAAP financial measures made in connection with a business combination transaction extended to non-GAAP financial measures contained in registration statements, proxy statements, and tender offer materials. The staff noted that disclosures of non-GAAP financial measures made in communications subject to 1933 Act Rule 425 or 1934 Act Rules 14a-12 or 14d-2(b)(2) are exempt from Regulation G and Item 10(e) of Regulation S-K. According to the staff:

[t]his exemption also [wa]s intended to apply to communications subject to Rule 14d-9(a)(2). This exemption does not extend beyond communications that are subject to those rules. [Thus], if the same non-GAAP financial measure that was included in a communication filed under one of those rules [wa]s also disclosed in a [1933] Act registration statement or a [1934] Act proxy statement or tender offer statement, the exemption would be inapplicable to that disclosure.

U.S. Securities Exchange Commission Frequently Asked Questions Regarding the Use of Non-GAAP Financial Measures, Transition Issues, Question 2 (June 13, 2003), http://www.sec.gov/divisions/corpfin/faqs/nongaapfaq.htm. Disclosures subject to Item 1015 of Regulation M-A are also exempt from Regulation G and Item 10(e) of Regulation S-K. This exemption:

is not limited to pre-commencement communications and, accordingly, the exemption would also be available for Item 1015 disclosure found in registration statements, proxy statements[,] and tender offer statements.

[In addition], where reconciliation of a non-GAAP financial measure is required and the most directly comparable measure is a []pro forma[] measure prepared and presented in accordance with Article 11 of Regulation S-X, companies may use that measure for reconciliation purposes in[stead] of a GAAP financial measure.

Id. 249 Securities Act Release No. 8176, supra note 244, at 4822.


employees, numbers of subscribers, or numbers of advertisers); and

• ratios or statistical measures that are calculated using exclusively one or both of:

o financial measures calculated in accordance with GAAP; and

o operating measures or other measures that are not non-GAAP financial measures.250

“Non-GAAP financial measures” also do not include financial information that does not have the effect of providing numerical measures that are different from the comparable GAAP measure, such as:

• disclosure of amounts of expected indebtedness, including contracted and anticipated amounts;

• disclosure of amounts of repayments that have been planned or decided upon but not yet made;

• disclosure of estimated revenues or expenses of a new product line, so long as such amounts were estimated in the same manner as would be computed under GAAP; and

• measures of profit or loss and total assets for each segment required to be disclosed in accordance with GAAP.251

The definition of “non-GAAP financial measure” is not intended to capture all measures that have the effect of depicting either:

• a measure of performance that is different from that presented in the financial statements, such as income or loss before taxes or net income or loss, as calculated in accordance with GAAP; or

• a measure of liquidity that is different from cash flow or cash flow from operations computed in accordance with GAAP.252

An example of a non-GAAP financial measure would be a measure of operating income that excludes one or more expense or revenue items that are identified as “non-recurring.”253

250 Id. 251 Id. 252 Id. 253 Id.


Another example would be EBITDA, which could be calculated using elements derived from GAAP financial presentations but, in any event, is not presented in accordance with GAAP.254

There is an exclusion from the definition of “non-GAAP financial measure” for financial measures required to be disclosed by GAAP, SEC rules, or a system of regulation of a government or governmental authority or self-regulatory organization that is applicable to the issuer.255

“Whenever a[n issuer] publicly discloses any material information that includes a non-GAAP financial measure, Regulation G requires the [issuer] to provide the following information as part of the disclosure or release of the non-GAAP financial measure:

• a presentation of the most directly comparable financial measure calculated and presented in accordance with GAAP; and

• a reconciliation (by schedule or other clearly understandable method), which shall be quantitative for historic measures and quantitative, to the extent available without unreasonable efforts, for prospective measures, of the differences between the non-GAAP financial measure presented and the most directly comparable financial measure or measures calculated and presented in accordance with GAAP.”256

“If a non-GAAP financial measure is released orally, telephonically, by webcast, by broadcast, or by similar means, the [issuer] may provide the accompanying information required by Regulation G by: (1) posting that information on the [issuer]’s web site and (2) disclosing the location and availability of the required accompanying information during its presentation.”257

“With regard to the quantitative reconciliation of non-GAAP financial measures that are forward-looking, Regulation G requires a schedule or other presentation detailing the differences between the forward-looking non-GAAP financial measure and the appropriate forward-looking GAAP financial measure.258 If the GAAP financial measure is not accessible on a forward-looking basis, the [issuer] must disclose that fact and provide reconciling information that is available without an unreasonable effort.259 Furthermore, the [issuer] must identify information that is unavailable and disclose its probable significance.”260

“Regulation FD and Regulation G [are intended to] operate in tandem.261 A ‘private’

254 Id. 255 Id. at 4822. 256 Id. at 4823. 257 Id. 258 Id. 259 Id. 260 Id. 261 Id.


communication of material, non-public information to, for example, an analyst or a shareholder triggers a requirement for broad public disclosure under Regulation FD.262 If that public disclosure is of material information containing a non-GAAP financial measure, Regulation G will apply to that disclosure.”263

“The amendments to Item 10 of Regulation S-K . . . require [issuers] using non-GAAP financial measures in filings with the [SEC] to provide:

• a presentation, with equal or greater prominence, of the most directly comparable financial measure calculated and presented in accordance with GAAP;

• a reconciliation (by schedule or other clearly understandable method), which shall be quantitative for historical non-GAAP measures presented, and quantitative, to the extent available without unreasonable efforts, for forward-looking information, of the differences between the non-GAAP financial measure disclosed or released with the most directly comparable financial measure or measures calculated and presented in accordance with GAAP;

• a statement disclosing the reasons why the [issuer]’s management believes that presentation of the non-GAAP financial measure provides useful information to investors regarding the [issuer]’s financial condition and results of operations; and

• to the extent material, a statement disclosing the additional purposes, if any, for which the [issuer]’s management uses the non-GAAP financial measure that are not otherwise disclosed.”264

“In addition to these mandated disclosure requirements, amended Item 10 of Regulation S-K prohibits the following:

• excluding charges or liabilities that required, or will require, cash settlement, or would have required cash settlement absent an ability to settle in another manner, from non-GAAP liquidity measures, other than the measures EBIT and EBITDA;

• adjusting a non-GAAP performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual, when (1) the nature of the charge or gain is such that it is reasonably likely to recur within two years, or

262 Id. 263 Id. 264 Id. at 4824 (footnotes omitted).


(2) there was a similar charge or gain within the prior two years;

• presenting non-GAAP financial measures on the face of the [issuer]’s financial statements prepared in accordance with GAAP or in the accompanying notes;

• presenting non-GAAP financial measures on the face of any pro forma financial information required to be disclosed by Article 11 of Regulation S-X; and

• using titles or descriptions of non-GAAP financial measures that are the same as, or confusingly similar to, titles or descriptions used for GAAP financial measures.”265

“EBIT and EBITDA [are exempted] from this provision because of their wide and recognized existing use.266 However, [issuers] must reconcile these measures to their most directly comparable GAAP financial measure. . . .”267

“[R]egard[ing] the quantitative reconciliation of non-GAAP financial measures [which] are forward-looking, Item 10 of Regulation S-K . . . require[s] a schedule or other presentation detailing the differences between the forward-looking non-GAAP financial measure and the appropriate forward-looking GAAP financial measure.268 If the GAAP financial measure is not accessible on a forward-looking basis, the [issuer] must disclose that fact and provide reconciling information that is available without an unreasonable effort.”269

B. Form 8-K Filings of Earnings Releases

As discussed previously, the SEC has reworked the regulatory framework for current reports on Form 8-K.270 In addition to adding new disclosure items, the SEC also accelerated the filing deadlines for Form 8-K.

The addition of Item 2.02 to Form 8-K requires issuers to furnish to the SEC all releases or announcements disclosing material non-public financial information about completed

265 Id. 266 Id. 267 Id. 268 Id. at 4825. 269 Id. 270 Additional Form 8-K Disclosure Requirements and Acceleration of Filing Date, Securities Act Release No.

8400, Exchange Act Release No. 49,424, 69 Fed. Reg. 15,594 (Mar. 25, 2004) (codified as amended in scattered parts of 17 C.F.R.), available at http://www.sec.gov/rules/final/33-8400.pdf, as amended by Additional Form 8-K Disclosure Requirements and Acceleration of Filing Date; Correction, Securities Act Release No. 8400A, Exchange Act Release No. 49,424A, 69 Fed. Reg. 48,370 (Aug. 10, 2004) (the “Form 8-K Release”), available at http://www.sec.gov/rules/final/33-8400a.pdf.


annual or quarterly fiscal periods.271 Item 2.02 does not require that companies issue earnings releases or similar announcements. However, such releases and announcements will trigger the requirements of Item 2.02.272

Item 2.02 requires issuers to furnish to the SEC a Form 8-K, within four business days of any public announcement or release disclosing material non-public information regarding an issuer’s results of operations or financial condition for an annual or quarterly fiscal period that has ended, that identifies the announcement or release and includes the text thereof as an exhibit.273

Repetition of information that was publicly disclosed previously or the release of the same information in a different form (for example in an interim or annual report to shareholders) would not trigger the Item 2.02 requirement.274 This result would not change if the repeated information were accompanied by information that was not material, whether or not already public.275 However, release of additional or updated material non-public information regarding the issuer’s results of operations or financial condition for a completed fiscal year or quarter would trigger an additional Item 2.02 obligation.276 The requirement to furnish a Form 8-K under Item 2.02 would not apply to issuers that make these announcements and disclosures only in, or approximately contemporaneously with, their quarterly reports filed with the SEC on Form 10-Q or their annual reports filed with the SEC on Form 10-K.277

An issuer could make the required Form 8-K Item 2.02 disclosure in the text of, and file the release as an exhibit to, a Form 10-K or 10-Q Report.278 Thus, an issuer could release earnings within four business days prior to the filing of its Form 10-K or 10-Q Report without filing a Form 8-K with the Item 2.02 information, although in the Form 10-K or 10-Q the issuer would have to disclose the substance of the release and file the release as an exhibit thereto.279

Item 2.02 includes an exception from its requirements where non-public information is disclosed orally, telephonically, by webcast, by broadcast, or by similar means in a presentation that is complementary to, and occurs within 48 hours after, a related, written release or announcement that triggers the requirements of Item 2.02.280 In this situation, Item 2.02 would not require the issuer to furnish an additional Form 8-K with regard to the information that is disclosed orally, telephonically, by webcast, by broadcast, or by similar means if:

271 Securities Act Release No. 8176, supra note 244, at 4825. 272 Id. 273 Id. 274 Id. 275 Id. at 4825–26. 276 Id. at 4826. 277 Id. 278 Id. at 4826–27; see also Instruction 4 to Form 8-K Item 2.02, http://www.sec.gov/about/forms/form8-k.pdf. 279 Securities Act Release No. 8176, supra note 244, at 4825–26. 280 Id. at 4826.


• the related, written release or announcement has been furnished to the SEC on Form 8-K pursuant to Item 2.02 prior to the presentation;

• the presentation is broadly accessible to the public by dial-in conference call, webcast or similar technology;

• the financial and statistical information contained in the presentation is provided on the issuer’s web site, together with any information that would be required under Regulation G; and

• the presentation was announced by a widely disseminated press release that included instructions as to when and how to access the presentation and the location on the issuer’s web site where the information would be available.281

Item 2.02 of Form 8-K will apply only to publicly disclosed or released material non-public information concerning an annual or quarterly fiscal period that has ended.282 While such disclosure may also include forward-looking information, it is the material information about the completed fiscal period that triggers Item 2.02.283 Item 2.02 does not apply to disclosure of earnings for future or ongoing fiscal periods which are not included in a disclosure of previously undisclosed information about completed periods.284

The most significant implications of “furnishing” a Form 8-K to the SEC, rather than “filing” a Form 8-K with the SEC, are:

• information that is “furnished to the SEC” in such a Form 8-K is not subject to § 18 of the 1934 Act unless the issuer specifically states that the information is to be considered “filed”;

• information that is “furnished” to the SEC in such a Form 8-K is not incorporated by reference into a registration statement, proxy statement or other report unless the issuer specifically incorporates that information into those documents by reference; and

• information that is “furnished” to the SEC in such a Form 8-K is not subject to the requirements of amended Item 10 of Regulation S-K while “filed” information would be subject to those requirements.285

281 Id. 282 Id. 283 Id. 284 Id. 285 Id. (footnote omitted).


Item 2.02 of Form 8-K requires that earnings releases or similar disclosures be furnished to the SEC rather than filed.286 Regulation G would, of course, apply to these releases and disclosures.287 In addition to the requirements already imposed by Regulation G, issuers would be required to disclose:

• the reasons why the issuer’s management believes that presentation of the non-GAAP financial measure provides useful information to investors regarding the issuer’s financial condition and results of operations; and

• to the extent material, the additional purposes, if any, for which the issuer’s management uses the non-GAAP financial measure that are not otherwise disclosed.288

Issuers may satisfy this requirement by including the disclosure in Form 8-K or in the release or announcement that is included as an exhibit to Form 8-K.289 As indicated above, issuers also may satisfy the requirement to provide these additional two statements by including the disclosure in their most recent annual report filed with the SEC (or a more recent filing) and by updating those statements, as necessary, no later than the time Form 8-K is furnished to the SEC.290

Earnings releases and similar disclosures that trigger the requirements of Item 2.02 are also subject to Regulation FD.291 The application of Item 2.02 would differ from Regulation FD, however, in that the requirements of Item 2.02 would always implicate Form 8-K for those disclosures, while Regulation FD provides that Form 8-K is an alternative means of satisfying its requirements.292

C. Prohibition on Loans to Directors or Officers

SOX § 402 generally “prohibits[, effective July 30, 2002,] a [corporation] from . . . [directly or indirectly] making or arranging for [personal] loans to [its] directors and executive officers.”293

286 Id. 287 Id. 288 Id. 289 Id. at 4826–27. 290 Id. at 4827. 291 Id. 292 Id. 293 Foreign Bank Exemption From the Insider Lending Prohibition of Exchange Act Section 13(k), Exchange Act

Release No. 48,481, 68 Fed. Reg. 54,590, 54,590 (proposed Sept. 11, 2003), available at http://www.sec.gov/rules/proposed/34-48481.htm; SOX Section 402(a) provides:

It shall be unlawful for any issuer (as defined in [SOX Section 2]), directly or indirectly, including through any subsidiary, to extend or maintain credit, to arrange for the extension of credit, or to renew an extension of credit, in the form of a personal loan to or for any director or executive officer (or equivalent thereof) of that issuer. An extension of credit maintained by the issuer on the date of enactment of this subsection shall not be subject to the provisions of this subsection, provided that


“Four categories of personal loans [by an issuer to its directors and officers] are expressly exempt from SOX § 402’s prohibition:294

(1) any extension of credit existing before [SOX’s] enactment as long as no material modification or renewal of the extension of credit occurs on or after the date of [SOX’s] enactment [on July 30, 2002];

(2) specified home improvement and consumer credit loans if:

• made in the ordinary course of the issuer’s consumer credit business,

• of a type generally made available to the public by the issuer, and

• on terms no more favorable than those offered to the public;

(3) loans by a broker-dealer to its employees that:

• fulfill the three conditions of paragraph (2) above,

• are made to buy, trade or carry securities other than the broker-dealer’s securities, and

• are permitted by applicable Federal Reserve System regulations; and

(4) any loan made or maintained by an insured depository institution (as defined in [§] 3 of the Federal Deposit Insurance Act (12 U.S.C. 1813)), if the loan is subject to the insider lending restrictions of [§] 22(h) of the Federal Reserve Act (12 U.S.C. 375b).”295

The SEC to date has not provided guidance as to the interpretation of SOX § 402, although a number of interpretative issues have surfaced. The prohibitions of SOX § 402 apply only to an extension of credit “in the form of a personal loan,” which suggests that all extensions of credit to a director or officer are not proscribed.296 While there is no legislative

there is no material modification to any term of any such extension of credit or any renewal of any such extension of credit on or after that date of enactment.

Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, § 402(a), 116 Stat. 745, 787-88 (codified at 15 U.S.C. § 78m(k) (Supp. III 2003)) [hereinafter SOX § 402].

294 Exchange Act Release No. 48,481, supra note 293, at 54,590; see also SOX § 402, supra note 293. 295 Exchange Act Release No. 48,481, supra note 293, at 54,590; see SOX § 402, supra note 293. “This last

exemption applies only to an “insured depository institution,” which [is] defined by the Federal Deposit Insurance Act (“FDIA”) [as] a bank or savings association that has insured its deposits with the Federal Deposit Insurance Corporation (“FDIC”).” Exchange Act Release No. 48,481, supra note 293, at 54,590; Foreign Bank Exemption from the Insider Lending Prohibition of Exchange Act Section 13(k), Exchange Act Release 49,616, 69 Fed. Reg. 24,016 (Apr. 26, 2004), http://www.sec.gov/rules/final/34-49616.pdf.

296 Sarbanes-Oxley Act: Interpretative Issues Under § 402—Prohibition of Certain Insider Loans, THE


history or statutory definition to guide, it is reasonable to take the position that the following, in the ordinary course of business, are not proscribed: travel and similar advances, ancillary personal use of company credit card, or company car where reimbursement is required. Advances of relocation expenses ultimately to be borne by the issuer: stay and retention bonuses subject to reimbursement if the employee leaves prematurely; indemnification advances of expenses pursuant to typical charter, bylaw, or contractual indemnification arrangements; and tax indemnification payments to overseas-based officers.297

SOX § 402 raises issues with regard to cashless stock option exercises and has led a number of issuers to suspend cashless exercise programs.298 In a typical cashless exercise program, the optionee delivers the notice of exercise to both the issuer and the broker, and the broker executes the sale of some or all of the underlying stock on that day (T). Then, on or prior to the settlement date (T+3), the broker pays to the issuer the option exercise price and applicable withholding taxes, and the issuer delivers (i.e., issues) the option stock to the broker. The broker transmits the remaining sale proceeds to the optionee. When and how these events occur may determine the level of risk under SOX § 402.299 The real question is whether a broker-administered, same-day sale involves “an extension of credit in the form of a personal loan” made or arranged by the issuer. The nature of the arrangement can affect the analysis.300

Some practitioners questioned whether SOX § 402 prohibits directors and executive officers of an issuer from taking loans from employee pension benefit plans, which raised the further question of whether employers could restrict director and officer plan loans without

CORPORATE COUNSEL (2002), available at http://www.TheCorporateCounsel.net; SOX § 402, supra note 293. 297 See Sarbanes-Oxley Act: Interpretative Issues Under § 402—Prohibition of Certain Insider Loans, THE

CORPORATE COUNSEL (2002), available at http://www.TheCorporateCounsel.net (an outline authored jointly by a group of 25 law firms).

298 Id.; EDMOND T. FITZGERALD, ET AL., PUBLIC COMPANY CEO COMPENSATION: A REVIEW OF THE RECENT

REFORMS, IN ADVANCED DOING DEALS 2004: DEALMAKING IN THE NEW TRANSACTIONAL MARKETPLACE 441 (Practicing Law Institute ed., 2004).

299 See Cashless Exercise and Other SOXmania, THE CORPORATE COUNSEL (2002). 300 If the issuer delivers the option stock to the broker before receiving payment, the issuer may be deemed to

have loaned the exercise price to the optionee, perhaps making this form of program riskier than others. If the broker advances payment to the issuer prior to T+3, planning to reimburse itself from the sale of proceeds on T+3, that advance may be viewed as an extension of credit by the broker, and the question then becomes whether the issuer “arranged” the credit. The risk of this outcome may be reduced where the issuer does not select the selling broker or set up the cashless exercise program, but instead merely confirms to a broker selected by the optionee that the option is valid and exercisable and that the issuer will deliver the stock upon receipt of the option exercise price and applicable withholding taxes. Even where the insider selects the broker, the broker cannot, under Regulation T, advance the exercise price without first confirming that the issuer will deliver the stock promptly. In that instance, the issuer’s involvement is limited to confirming facts, and therefore is less likely to be viewed as “arranging” the credit. Where both payment and delivery of the option stock occur on the same day (T+3), there arguably is no extension of credit at all, in which case the exercise should not be deemed to violate SOX Section 402 whether effected through a designated broker or a broker selected by the insider. If the insider has sufficient collateral in his or her account (apart from the stock underlying the option being exercised) to permit the broker to make a margin loan equal to the exercise price and applicable withholding taxes, arguably the extension of credit is between the broker and the insider and does not violate SOX Section 402 assuming the issuer is not involved in arranging the credit. Interpretative Issues Under § 402, supra note 297.


violating the U.S. Labor Department’s antidiscrimination rules.301 In response, the Labor Department issued Field Assistance Bulletin 2003-1 providing that plan fiduciaries of public companies could deny participant loans to directors and officers without violating the Labor Department rules.302

D. Accelerated § 16(a) Reporting

SOX § 403 amends § 16(a) of the 1934 Act, effective August 29, 2002, to require officers, directors, and 10% shareholders (collectively, “insiders”) of companies with securities registered under § 12 of the 1934 Act to file with the SEC Form 4 reporting (i) a change in ownership of equity securities or (ii) the purchase or sale of a security based swap agreement involving an equity security “before the end of the second business day following the business day on which the subject transaction has been executed.”303

1. Two Business Days to File Form 4

On August 27, 2002, the SEC issued a release (the “16(a) Release”) adopting final amendments to its rules and forms implementing the accelerated filing deadlines described above for transactions subject to § 16(a).304 As anticipated, the rule amendments also subject all transactions between officers or directors and the issuer, exempted from § 16(b) short-swing profit recovery by Rule 16b-3, which were previously reportable on an annual basis on Form 5 (including stock option grants, cancellations, regrants, and repricings) to § 16(a) and the new two business day reporting requirement on Form 4.305

The SEC has enacted two narrow exceptions to the new two business day reporting requirement, which apply only if the insider does not select the date of execution of the transaction.306 These exceptions include: (1) transactions pursuant to a contract, instruction, or written plan for the purchase or sale of issuer securities that satisfies the affirmative defense conditions of Rule 10b5-1(c) (including, according to the 16(a) Release, transactions pursuant to employee benefit plans and dividend and interest reinvestment plans that are not already exempt from § 16(a) reporting) and (2) “discretionary transactions” (as defined in Rule 16b-

301 See GAUDREAU, JR., RUSSELL A. & SOLVEIG R. MCSHEA, PLAN LOANS TO PARTICIPANTS AND

BENEFICIARIES, IN ADVANCED LAW OF PENSIONS, WELFARE PLANS, AND DEFERRED COMPENSATION, 1547, 1570 (American Law Institute ed., 2004).

302 U.S. Department of Labor, Field Assistance Bulletin 2003-1 (Apr. 14, 2003), http://www.dol.gov/ebsa/regs/fab_2003_1.html.

303 SOX § 403, amending 15 U.S.C.A. § 78p (West Supp. 2007) (emphasis added) [hereinafter SOX § 403]. Previously, Form 4 was required to be filed by the 10th day of the month following the month in which the transaction was executed.

304 Ownership Reports and Trading by Officers, Directors and Principal Security Holders, Exchange Act Release No. 46,421, Investment Company Act Release No. 25,720, 67 Fed. Reg. 56,462, 56,462 (Sept. 3, 2002), available at http://www.sec.gov/rules/final/34-46421.htm [hereinafter 16(a) Release].

305 Id. at 56,463. 306 For example, the SEC pointed out in the 16(a) Release that transactions pursuant to a Rule 10b5-1(c)

arrangement which specify a date for purchases for sales (e.g., the first business day of each month) would not qualify for this exception. Id. at 56,464.


3(b)(1)) involving an employee benefit plan, whether or not exempted by Rule 16b-3.307 In these cases, the date of execution (triggering the two-day deadline) is deemed to be the earlier of the date the executing broker, dealer, or plan administrator notifies the insider of the execution of the transaction or the third business day following the actual trade date of the transaction.308 Other transactions exempt from § 16(b) previously reportable on Form 5 will remain reportable on Form 5.309 These transactions include small acquisitions not from the issuer and gifts.310

In order to comply with these accelerated filing requirements, issuers need to create an early notification system which ensures that the issuer is promptly made aware of § 16(a) transactions by both insiders and administrators of their broad-based employee benefit plans. The SEC expects insiders to make arrangements with executing entities to provide such notification to the insider as quickly as feasible and urges executing entities to provide such information either electronically or by telephone and not rely on mailed confirmations.311

Additionally, the SEC’s rules reflect that Form 4 is not a monthly reporting form, but must be filed within two business days of the date of execution of the reported transaction.312 The SEC indicates that prior to publication of a new Form 4, insiders should use the old form, modifying Box 4 to state the month, date, and year of the transaction and, if applicable, including a footnote to include a deemed execution date in addition to the trade date.313

2. Website Posting

On May 7, 2003, the SEC issued Release No. 33-8230 adopting rules titled “Mandated Electronic Filing and Website Posting for Forms 3, 4 and 5.”314 These rules, which went into effect on June 30, 2003 amend Regulation S-T to require insiders to file Forms 3, 4 and 5 with the SEC on EDGAR.315 The rules also require an issuer that maintains a corporate website316 to post on its website all Forms 3, 4 and 5 filed with respect to its equity securities by the end of the business day after filing.317

307 Id. at 56,463–64. 308 Id. at 56,464–65. 309 Id. at 56,463. 310 Id. at 56,467. 311 See, e.g., id. at 56,465. 312 Id. at 56,463. 313 Id. 314 Mandated Electronic Filing and Website Posting For Forms 3, 4 and 5, Securities Act Release No. 8230,

Exchange Act Release No. 47,809, Investment Company Act Release No. 26,044, 68 Fed. Reg. 25,788 (May 13, 2003), available at http://www.sec.gov/rules/final/33-8230.htm.

315 Id. at 25,789. As amended, “Regulation S-T also requires the electronic filing of any related correspondence and supplemental information pertaining to a document that is the subject of mandated EDGAR [filing]. These materials [will] not [be] disseminated publicly but [will be] available to the [SEC] staff.” Id. at 25,789–90.

316 “[T]he term ‘corporate website’ refers to public (internet) sites,” as opposed to private (intranet) sites. Id. at 25,790.

317 Id.


An issuer can satisfy this requirement whether it provides access directly or by hyperlinking to reports via a third-party service instead of maintaining the forms itself if the following conditions are met:

• the forms are made available in the required time frame;

• access to the reports is free of charge to the user;

• the display format allows retrieval of all information in the forms;

• the medium to access the forms is not so burdensome that the intended users cannot effectively access the information provided;

• the access includes any exhibits or attachments;

• access to the forms is through the issuer website address the issuer normally uses for disseminating information to investors; and

• any hyperlink is directly to the § 16 forms (or to a list of the § 16 forms) relating to the posting issuer instead of just to the home page or general search page of the third-party service.318

The “form[s must] remain accessible on the issuer’s website [(or through the hyperlink)] for at least a twelve-month period.”319

In order to ease the administrative burdens on filers associated with switching to electronic filing of Forms 3, 4 and 5, the rules “amend [Regulation S-T] to provide that any Form 3, 4 or 5 submitted by direct transmission on or before 10 p.m. Eastern time is deemed filed on the same business day.320 However, filer support hours will not be correspondingly extended, so filer support will remain available only until 7:00 p.m. . . .”321

“The EDGAR system [is] programmed to provide that a form filed between 5:30 p.m. and 10:00 p.m. Eastern time [will be] assigned a filing date on the same business day and disseminated that evening.”322

Insiders are “require[d] . . . to send or deliver [a] duplicate” of each § 16 form to the issuer not later than the time the form is transmitted for filing with the Commission “to the person designated by the issuer to receive such statements, or, in the absence of such designation, to

318 Id. 319 Id. 320 Id. at 25,793. This extension applies only to Forms 3, 4, and 5. 321 Id. 322 Id.


the issuer’s corporate secretary or person performing equivalent functions.”323 An issuer which wishes to post the § 16 reports on its website directly should implement procedures to ensure that its insiders provide notice and electronic copies of filed § 16 reports in time to meet the posting date.324 An issuer that uses a hyperlink to an appropriate third-party site can avoid this concern.325

3. Procedures for Filing § 16(a) Reports on EDGAR

Summarized below are some of the procedures applicable in filing insider-trading reports on EDGAR.326

a. EDGAR Access Codes

A prerequisite to filing the reports electronically on EDGAR is obtaining a set of EDGAR access codes. This is done by filing with the SEC a Form ID, which is available on the SEC website.327 It is very important that a separate Form ID be completed for each insider whose filings will be made via EDGAR (under the old system, only one insider in a “group” needed to have the codes, but now each individual will be required to have his or her own set of codes). An individual who is an insider for more than one company need only file for one set of EDGAR access codes. It is also important to protect the integrity and security of the data sent by limiting the number of people who know the sender’s CCC, password, and PMAC. Thus, it may be prudent to apply for a certificate for added security purposes.328 One should also take note that the SEC has discontinued the acceptance of requests for access codes for EDGAR on Form ID through the mail. All requests for these codes must come via fax. Fax Form ID to:

US Securities and Exchange Commission ATTN: Filer Support (202) 504-2474; or (703) 916-4240

The SEC will also no longer return a hard copy of the access codes through the mail but will notify the applicant of the codes via telephone. If a written confirmation of the codes is desired, include either an e-mail address or a fax number with the request.

Four EDGAR access codes will be created after filing the Form ID. One of the codes created is the Central Index Key (“CIK”) code. The CIK code uniquely identifies each filer, filing agent, and training agent. The CIK is assigned after the filing of an initial application. This code cannot be changed. Another code that will be created is the CIK Confirmation Code (“CCC”). The CCC is used in the header of filings in conjunction with the CIK to ensure that the filing is authorized. The third code that is created is the password. The password allows a

323 Id. at 25,790. 324 Id. 325 Id. 326 See the EDGAR Filer Manual, http://www.sec.gov/info/edgar/edmanuals93.htm. 327 See SEC website, http://www.sec.gov/about/forms/formid.pdf. 328 See the EDGAR Filer Manual, http://www.sec.gov/info/edgar/edmanuals93.htm.


person to log into EDGAR, submit filings, and change the CCC. Finally, holders of access codes will receive a Password Modification Authorization Code (“PMAC”). The PMAC allows a person to change their password.

b. Use of a Filing Service

Once the EDGAR access codes have been obtained and the necessary information for the applicable form has been compiled, an insider may electronically file the form with the assistance of a filing agent such as a financial printer or law firm.

These companies allow submissions to be reduced content filings. A reduced content filing is a filing that provides header information (e.g., form type) and data for mandatory fields that are specified and otherwise complies with the technical filing requirements. When using a reduced content filing, a filer is able to save material (enabling the filer to cut and paste from one form to the next), and the filer does not have to create the headings and instructions on the form, only the content. Reduced content filings will enable issuers and insiders to use third-party service providers for filings, if they wish to do so, just as they do today.

c. Filing By or On Behalf of Insider

If an insider wishes to file on his own behalf or the issuer desires to file on behalf of the insider, one will need to refer to Regulation S-T329 which sets forth the rules for filing electronically and the EDGAR Filer Manual, which describes the procedures and technical formatting requirements of EDGAR, in addition to this memorandum.330 He or she will need to go to the EDGAR Login page331 and enter the CIK and password and click the Login to EDGAR button. A button on the menu will give filers the option to create an on-line Form 3, 4, or 5, or an amendment to any of these forms. The filer should have all the necessary information (codes, etc.) available before going on-line to file. Due to cost and technical limitations, data entry must be performed quickly enough to avoid time-outs that end the session. A time-out will occur one hour following the user’s last activity on the system. The system is not able to provide a way to save an incomplete form on-line from session to session. The system will validate as many fields as possible for date type and required fields while the filer fills in the form. Filers will have the chance to correct errors and verify the accuracy of the information before submitting the filing. An on-line help function is also available.

The filer can download and print the filing and add attachments before submission. Once the filing is submitted, the system will display the accession number of the filing or a message that says the accession number will follow in a return notification. An accession number is a unique number generated by EDGAR for each electronic submission. Assignment of an accession number does not mean that EDGAR has accepted a submission. A filer can obtain a return copy of the form shortly after filing and can view the filing on the SEC’s website.332 Filers who submit their forms directly by entering information into the online templates must

329 17 C.F.R. § 232 (2008). 330 Id.; EDGAR Filer Manual, supra note 326. 331 See EDGAR login page, https://www.edgarfiling.sec.gov. 332 See SEC website, http://www.sec.gov/about/forms/formid.pdf.


click the “transmit submission” button on or before 10:00 p.m. EST on a commission business day for the submission to be completed that day. Similarly, a reduced content filing must begin transmission on or before 10:00 p.m. EST to be completed the same day.

Please take note that an insider must submit a paper copy of his first electronic filing. Send the paper copy to the following address:

Operation Location ATTN: Filer Support US Securities and Exchange Commission Mail Stop 0-7 6432 General Green Way Alexandria, VA 22312

d. Additional Points to Consider

The following points should also be considered in preparing to file an insider report via EDGAR:

• An individual cannot use a company’s password for his or her insider trading report. If an insider uses the company’s EDGAR password, even if the filing is initially accepted by EDGAR, it will not “count” as being filed by the individual. Further, each individual or company filing on behalf of an individual needs to make sure that it has only one EDGAR password for the individual in advance of any filing.

• Individuals should apply for EDGAR access codes well in advance. Historically, it has taken two to three business days to receive EDGAR access codes. However, due to the new two-day requirement for Form 4, it may take longer.

• If an insider wishes to file on his own behalf or the issuer desires to file on behalf of the insider without the aid of a filing service, it is recommended that the applicable persons prepare the submissions well in advance of the filing and use the Submission Validation features on EDGAR.

• Keep a manually signed signature page (or equivalent document) on file for five years.

• Filer Support Staff are available each business day from 8:00 a.m. to 7:00 p.m. EST. They can be reached at (202) 942-8900.

E. Internal Controls

SOX § 404 directs the SEC to prescribe rules mandating inclusion in Form 10-K annual reports of: (i) a report by management on the issuer’s internal control over financial reporting (“ICFR”) and (ii) a PCAOB registered accounting firm’s attestation report on the effectiveness of the issuer’s ICFR.333 The rules implementing SOX § 404 define ICFR as: “a process

333 SOX § 404, 15 U.S.C.A. § 7262 (West Supp. 2007) [hereinafter SOX § 404]. SOX § 404 requires the SEC to adopt rules requiring a company’s management to present an internal control report in the company’s annual report


designed by, or under the supervision of, the issuer’s principal executive and principal financial officers, or persons performing similar functions, and effected by the issuer’s board of directors, management, and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP and includes those policies and procedures that:

1. Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the issuer;

2. Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the issuer are being made only in accordance with authorizations of management and directors of the issuer; and

3. Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the issuer’s assets that could have a material effect on the financial statements.”334

The SEC rules implementing SOX § 404335 require each reporting company to include in its Form 10-K an ICFR report of management that includes:

• A statement that it is management’s responsibility to establish and maintain adequate ICFR for the issuer;336

containing: (1) a statement of the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting, and (2) an assessment, as of the end of the company’s most recent fiscal year, of the effectiveness of the company’s internal control structure and procedures for financial reporting. SOX § 404 also requires the company’s registered public accounting firm to attest to, and report on, management’s assessment. The SOX § 404 requirements did not become applicable until the SEC’s implementing rules became effective. The SEC’s implementing rules, as amended, only require a single audit opinion directly on the effectiveness of the issuer’s ICFR and the SEC believes this to be consistent with SOX § 404 and SOX § 103. See infra note 339.

334 17 C.F.R. § 240.13a-15 (2008) (with regard to Regulation 13A); 17 C.F.R. § 240.15d-15 (2008) (with regard to Regulation 15D).

335 Management’s Report on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports, Securities Act Release No. 8238, Exchange Act Release No. 47,986, Investment Company Act Release No. 26,068, 80 SEC Docket 1014 (June 5, 2003), available at http://www.sec.gov/rules/final/33-8238.htm (the “Internal Control Release”).

336 The PCAOB notes that:

Controls over financial reporting may be preventive controls or detective controls. . . . Preventive controls have the objective of preventing errors or fraud that could result in a misstatement of the financial statements from occurring [(e.g., segregation of duties; two check signers)]. Detective controls have the objective of detecting errors or fraud that has already occurred that could result in a misstatement of the financial statements [(e.g., regular reconciliation of accounts payable and accounts receivable)].

PCAOB Accounting Standards PCAOB Release 2007-005A (June 12, 2007) at A-8. “Effective ICFR often includes a combination of preventive and detective controls.” Id.


• A statement identifying the framework337 used by management to conduct the required evaluation of the effectiveness of the issuer’s ICFR; and

• Management’s assessment of the effectiveness of the issuer’s ICFR as of the end of the issuer’s most recent fiscal year, including a statement as to whether or not the issuer’s ICFR is effective. The assessment must include disclosure of any “material weaknesses” in the issuer’s ICFR identified by management. Management is not permitted to conclude that the issuer’s ICFR is effective if there are one or more material weaknesses in the issuer’s ICFR; and

• In addition to management’s assessment on ICFR, the Form 10-K Report must include an attestation report of the issuer’s auditor as to the effectiveness of the issuer’s ICFR.338 SOX § 404(b) requires the auditor to “attest to, and report on, the assessment made by the management of the issuer, [and SOX § 103(a)(2)(A)(iii)] requires that each audit report describe the scope of the auditor’s testing of the [issuer’s ICFR] structure and procedures and present, among other information: (1) the findings of the auditor from such testing; (2) an evaluation of whether such internal control structure and procedures provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with [GAAP]; and (3) a description of [any] material weaknesses in such [ICFR]. The [SEC] believes that a [single] audit opinion directly on the effectiveness of [the issuer’s] ICFR is consistent with both [SOX §] 404 and [SOX §] 103[, and its rules now so require.]”339

337 The framework on which management’s evaluation is based must be a suitable, recognized control framework

that is established by a body or group that has followed due-process procedures, including the broad distribution of the framework for public comment. The SEC staff has indicated that the evaluative framework set forth in the 1992 Treadway Commission report on internal controls (also known as the COSO Report), available at http://www.coso.org, will be a suitable framework, and that foreign private issuers will be permitted to use the framework in effect in their home countries. In the COSO Report, the term “control environment” encompasses the attitudes and values of executives and directors and the degree to which they recognize the importance of method, transparency, and care in the creation and execution of their company’s policies and procedures. A proper control environment is one factor an external auditor considers when called upon to evaluate internal control over financial reporting pursuant to SOX § 404. Stephen Wagner & Lee Dittmar, The Unexpected Benefits of Sarbanes-Oxley, Best Practice, HARVARD BUS. REV. 133, 134 (2006).

338 17 C.F.R. § 210.2-02 (2008); Amendments to Rules Regarding Management’s Report on Internal Control Over Financial Reporting, Securities Act Release Act No. 8809, Exchange Act Release No. 55,928, 72 Fed. Reg. 35,310 (June 20, 2007), available at http://www.sec.gov/rules/final/2007/33-8809.pdf.

339 Amendments to Rules Regarding Management’s Report on Internal Control Over Financial Reporting, 72 Fed. Reg. at 35,313; SOX § 103(a)(2)(A)(iii) states that:

each registered public accounting firm shall —

describe in each audit report the scope of the auditor’s testing of the internal control structure and procedures of the issuer, required by section 404(b), and present (in such report or in a separate report)—

(I.) the findings of the auditor from such testing;

(II.) an evaluation of whether such internal control structure and procedures –


Under these SOX § 404 rules, management must disclose any material weakness and will be unable to conclude that the issuer’s ICFR is effective if there are one or more material weaknesses in such control.340 The term “material weakness” is now defined in 1934 Act Rule 12b-2 as “a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis.”341 The SOX § 404 rules require reporting companies to perform quarterly evaluations of changes that have materially affected, or are reasonably likely to materially affect, the issuer’s ICFR.342

Compliance with the SOX § 404 rules proved difficult and expensive for issuers. In response, on May 23, 2007 the SEC issued interpretive guidance to help public companies strengthen their ICFR while reducing unnecessary costs, particularly at smaller companies, by focusing company management on the internal controls that best protect against the risk of a material financial misstatement and enabling issuers to scale and tailor their evaluation procedures according to the facts and circumstances.343 This guidance was principles based to afford flexibility to issuers and, notwithstanding requests from some commentators for more specific guidance, does not contain detailed rules, which the SEC feared some issuers might learn how to game. An issuer that performs an evaluation of internal control in accordance with the interpretive guidance satisfies the annual evaluation required by 1934 Act Rules 13a-15 and 15d-15.

Then on May 24, 2007, the PCAOB adopted Auditing Standard No. 5, An Audit of Internal Control Over Financial Reporting That is Integrated with An Audit of Financial Statements (“AS 5”).344 AS 5 was approved by the SEC on July 25, 2007345 and superseded

(aa) include maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the issuer;

(bb) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the issuer are being made only in accordance with authorizations of management and directors of the issuer; and

(III.) a description, at a minimum, of material weaknesses in such internal controls, and of any material noncompliance found on the basis of such testing.

Id. n.33. 340 Id. at 35,312–13. 341 Id. at 35,313. 342 17 C.F.R. §§ 240.13a-15(a), 240.15d-15(f) (2008). 343 Commission Guidance Regarding Management’s Report on Internal Control Over Financial Reporting Under

Section 13(a) or 15(d) of the Securities Exchange Act of 1934, Securities Act Release No. 8810, Exchange Act Release No. 55,929, 72 Fed. Reg. 35,324 (June 20, 2007), available at http://www.sec.gov/rules/interp/2007/33-8810.pdf.

344 PCAOB Auditing Standard No. 5, available at http://www.pcaobus.org/Standards/ Standards_and_Related_Rules/Auditing_Standard_No.5.aspx.

345 Public Company Accounting Oversight Board: Order Approving Proposed Auditing Standard No. 5, An Audit of Internal Control Over Financial Reporting that is Integrated with an Audit of Financial Statements, a Related Independence Rule, and Conforming Amendments, Exchange Act Release No. 56,152, 91 SEC Docket 522 (July 27,


PCAOB Auditing Standard No. 2 (“AS 2”); AS 2 was adopted by the PCAOB in March 2004 and approved by the SEC in June 2004. The new AS 5 standard will apply to audits of all companies required by SEC rules to obtain an audit of ICFR. In adopting AS 5, the PCAOB commented that AS 5 “results from the [PCAOB]’s monitoring of auditors’ implementation of [AS] 2 through, among other things, inspections of internal control audits and public roundtable discussions held in April 2005 and May 2006 [and that w]hile the [PCAOB] observed significant benefits produced by the [ICFR] audit [under AS 2], including higher quality financial reporting, it also noted that, at times, the related effort has appeared greater than necessary to conduct an effective audit.”346 Based on these observations, and in light of the approaching date for smaller companies to comply with the SOX § 404 reporting requirements, the PCAOB adopted AS 5 to achieve four objectives:

1. Focus the Internal Control Audit on the Most Important Matters—AS 5 focuses auditors on those areas that present the greatest risk that an issuer’s ICFR will fail to prevent or detect a material misstatement in the financial statements. It does so by incorporating certain best practices designed to focus the scope of the audit on identifying material weaknesses in internal control, before they result in material misstatements of financial statements, such as using a top-down approach to planning the audit. It also emphasizes the importance of auditing higher risk areas, such as the financial statement close process and controls designed to prevent fraud by management. At the same time, it provides auditors a range of alternatives for addressing lower risk areas, such as by more clearly demonstrating how to calibrate the nature, timing and extent of testing based on risk, as well as how to incorporate knowledge accumulated in previous years’ audits into the auditors’ assessment of risk and use the work performed by companies’ own personnel, when appropriate.

2. Eliminate Procedures that Are Unnecessary to Achieve the Intended Benefits—After examining the ICFR audit processes to determine whether the previous standard encouraged auditors to perform procedures that are not necessary to achieve the intended benefits of the audit, the PCAOB decided not to include in detailed requirements to evaluate management’s own evaluation process and to clarify that an internal control audit does not require an opinion on the adequacy of management’s process. As another example, AS 5 refocuses the multi-location direction on risk rather than coverage by removing the requirement that auditors test a “large portion” of the company’s operations or financial position.

3. Make the Audit Clearly Scalable to Fit the Size and the Complexity of Any Company—In coordination with PCAOB’s ongoing project to develop guidance for auditors of smaller, less complex companies, AS 5 explains how to tailor internal control audits to fit the size and complexity of the company being audited. AS 5 does so by including notes throughout the standard on how to apply the principles in the standard to smaller, less complex companies, and by including a discussion of the relevant attributes of smaller, less complex companies as well as less complex units of larger companies.

2007), available at http://www.sec.gov/rules/pcaob/2007/34-56152.pdf. 346 Press Release, Public Company Accounting Oversight Board, Board Approves New Audit Standard For

Internal Control Over Financial Reporting and, Separately, Recommendations on Inspection Frequency Rule (May 24, 2007), available at http://www.pcaobus.org/News_and_Events/News/2007/05-24.aspx.


4. Simplify the Text of the Standard—AS 5 eliminates the previous standard’s discussion of materiality, thus clarifying that the auditor’s evaluation of materiality for purposes of an ICFR audit is based on the same long-standing principles applicable to financial statement audits. AS 5 conforms certain terms to the SEC’s rules and guidance, such as the definition of “material weakness” and use of the term “entity-level controls”347 instead of “company-level controls.”348

Compliance with the rules regarding management’s report on ICFR is required as follows: accelerated filers are required to comply with the management report on ICFR requirements for fiscal years ending on or after November 15, 2004, and all other domestic issuers (including small business issuers) will be required to comply with the SOX § 404(a) requirement of including management’s report on ICFR for fiscal years ending on or after December 15, 2007 and with the SOX § 404(b) requirement of including the auditor’s attestation report for fiscal years ending on or after December 15, 2009.349

347 Entity level controls include tone at the top and corporate governance, including the effectiveness of the audit

committee. 348 Press Release, Public Company Accounting Oversight Board, Board Approves New Audit Standard For

Internal Control Over Financial Reporting and, Separately, Recommendations on Inspection Frequency Rule (May 24, 2007), available at http://www.pcaobus.org/News_and_Events/News/2007/05-24.aspx.

349 Management’s Report on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports, Securities Act Release No. 8238, Exchange Act Release No. 47,986, Investment Company Act Release No. 26,068, 68 Fed. Reg. 36,650 (June 18, 2003), available at http://www.sec.gov/rules/final/33-8238.htm. “Accelerated filer” is defined in the rules of the Securities Exchange Act of 1934 generally as an issuer which had a public common equity float of $75 million or more as of the last business day of the issuer’s most recently completed second fiscal quarter and has been a reporting company for at least twelve months (other than foreign private issuers). 17 C.F.R. 240.12b-2 (2006). The dates were further extended to the dates set forth in the text by (i) Management’s Report on Internal Controls over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports, Securities Act Release No. 8392, Exchange Act Release No. 49,313, Investment Company Act Release No. 26,357, 82 SEC Docket 673 (Feb. 24, 2004), available at http://www.sec.gov/rules/final/33-8392.htm; (ii) Management’s Report on Internal Control over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports of Non-Accelerated Filers and Foreign Private Issuers, Securities Act Release No. 8545, Exchange Act Release No. 51,293, 84 SEC Docket 3226 (Mar. 2, 2005), available at http://sec.gov/rules/final/33-8545.htm; and (iii) Management’s Report on Internal Control over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports of Non-Accelerated Filers and Foreign Private Issuers, Securities Act Release No. 8618, Exchange Act Release No. 52,492, 70 Fed. Reg. 56,825 (Sept. 22, 2005), available at http://sec.gov/rules/final/33-8618.pdf. See also Order Under Section 36 of the Securities Exchange Act of 1934 Granting an Exemption from Specified Provisions of Exchange Act Rules 13a-1 and 15d-1, Exchange Act Release No. 50,754, 84 SEC Docket 945 (Nov. 30, 2004), available at http://www.sec.gov/rules/exorders/34-50754.htm (giving certain smaller accelerated filers an additional forty-five days after their Form 10-K is due to file their management’s assessment of the internal controls and the related auditor’s report thereon); Division of Corporation Finance FAQ on Exemptive Order on Management’s Report on Internal Control over Financial Reporting and Related Auditor Report Frequently Asked Questions (Jan. 21, 2005), http://www.sec.gov/divisions/corpfin/faq012105.htm (interpreting that order). In Amendments to Rules Regarding Management’s Report on Internal Control Over Financial Reporting, the SEC indicated that there would be no further extensions for “non-accelerated filers [which] are scheduled to begin including a management report on ICFR in their annual reports filed for a fiscal year ending on or after December 15, 2007 . . . and an auditor’s report on ICFR for a fiscal year ending on or after December 31, 2008.” Securities Act Release No. 8809, Exchange Act Release No. 55,928, 72 Fed. Reg. 35,310 (June 20, 2007), available at http://www.sec.gov/rules/final/2007/33-8809.pdf. Nevertheless, with the intention of providing the SEC and the PCAOB more time to complete initiatives intended to


F. Codes of Ethics

SOX § 406 directs the SEC to issue rules requiring a code of ethics350 for senior financial officers of an issuer applicable to the CFO, comptroller, or principal accounting officer and to require disclosure on its Form 8-K within four days of any change in or waiver of the code of ethics for senior financial officers.351

Code of Ethics Disclosures. On January 23, 2003, the SEC issued Release No. 33-8177, adopting rules titled “Disclosure Required by §§ 406 and 407 of the Sarbanes-Oxley Act of 2002,” that require reporting companies to disclose on Form 10-K:

• whether the issuer has adopted a code of ethics that applies to the issuer’s principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions; and

• if the issuer has not adopted such a code of ethics, the reasons it has not done so.352

In the adopted SOX § 406 rules “code of ethics” “mean[s a codification of] written standards reasonably designed to deter wrongdoing and to promote:

(1) [h]onest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships;

improve cost-effectiveness and efficiency of SOX § 404 compliance for smaller reporting companies, the SEC approved its proposal to delay the requirements that non-accelerated filers, including smaller reporting companies, include in their annual reports, pursuant to the rules implementing SOX § 404(b), an attestation report of their independent auditor on the issuer ICFR for one years to fiscal years ending on or after December 15, 2009. For annual reports for fiscal years ending before December 15, 2009, a non-accelerated filer must state in its management report that the company’s annual report does not include the auditor attestation report. Internal Control Over Financial Reporting in Exchange Act Periodic Reports of Non-Accelerated Filers, Securities Act Release No. 8934, Exchange Act Release No. 58,028 73 Fed. Reg. 38,094 (June 26, 2008), available at http://www.sec.gov/rules/final/2008/33-8934.pdf.

350 SOX § 406(c), 15 U.S.C.A. §7264(c) (West Supp. 2007) [hereinafter SOX § 406]. SOX § 406 defines a “code of ethics” to mean:

such standards as are reasonably necessary to promote:

(1) honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships;

(2) full, fair, accurate, timely, and understandable disclosure in the periodic reports required to be filed by the issuer; and

(3) compliance with governmental regulations. Id.

351 SOX § 406(b), supra note 350. 352 Disclosure Required by Sections 406 and 407 of the Sarbanes Oxley Act of 2002, Securities Act Release No.

8177, Exchange Act Release No. 47,235, 68 Fed. Reg. 5110, 5118 (Jan. 23, 2003) (codified at 17 C.F.R. 229.406(a) (2006)), available at http://www.sec.gov/rules/final/33-8177.htm [hereinafter SOX §§ 406/407 Release].


(2) [f]ull, fair, accurate, timely, and understandable disclosure in reports and documents that a company files with, or submits to, the [SEC] and in other public communications made by the company;

(3) [c]ompliance with applicable governmental laws, rules, and regulations;

(4) [t]he prompt internal reporting to an appropriate person or persons identified in the code of violations of the code;353 and

(5) [a]ccountability for adherence to the code.”354

The SOX § 406 rules indicate that in addition to providing the required disclosure an “issuer [may]:

(1) [f]ile with the [SEC] a copy of its code of ethics that applies to the [company]’s principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions, as an exhibit to its [Form 10-K] annual report;355

(2) [p]ost the text of such code of ethics on its Internet website and disclose, in its [Form 10-K] annual report, its Internet address and the fact that it has posted [its] code of ethics on its Internet [website];356 or

(3) [u]ndertake in its [Form 10-K] annual report filed with the [SEC] to provide to any person without charge, upon request, a copy of such code of ethics and explain the manner in which such request may be made.”357

Form 8-K or Internet Disclosure Regarding Changes to, or Waivers From, the Code of Ethics. The SOX § 406 code of ethics rules “add[] an item to the list of Form 8-K triggering events to require disclosure of:

• [t]he nature of any amendment to the company’s code of ethics that applies to its principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions;358 and

353 The company would retain discretion to choose the person to receive reports of code violations, but Securities

Act Release No. 8138, Exchange Act Release No. 46,701, infra note 367, suggests the person should have sufficient status within the company to engender respect for the code and authority to adequately deal with the persons subject to the code regardless of their stature within the company.

354 17 C.F.R. § 229.406(b) (2008). 355 17 C.F.R. §§ 228.406(c)(1), 229.406(c)(1) (2008). 356 17 C.F.R. §§ 228.406(c)(2), 229.406(c)(2) (2008). 357 17 C.F.R. §§ 228.406(c)(3), 229.406(c)(3) (2008). 358 SOX §§ 406/407 Release, supra note 352, at 5119; see generally SOX § 406(b), supra note 350.


• [t]he nature of any waiver, including an implicit waiver, from a provision of the code of ethics granted by the company to one of these specified officers, the name of the person to whom the company granted the waiver and the date of the waiver.”359

“Only amendments or waivers relating to the specified elements of the code of ethics and the specified officers must be disclosed.”360 In the SOX 406/407 Release, the SEC “clarifi[ed that this limitation] is intended to allow and encourage companies to retain broad-based business codes.361 For example, if a company has a code of ethics that applies to its directors, as well as its principal executive officer and senior financial officers, an amendment to a provision affecting only directors would not require Form 8-K or Internet disclosure.

A company choosing to provide the required disclosure on Form 8-K must do so within four business days after it amends its code or grants a waiver.362 As an alternative to reporting this information on Form 8-K, a company may use its Internet website as a method of disseminating this disclosure, but only if it previously has disclosed in its most recently filed annual report on Form 10-K . . . :

• its intention to disclose these events on its Internet website; and

• its Internet website address.”363

G. Audit Committee Financial Experts

SOX § 407 requires the SEC to promulgate rules mandating that each reporting company disclose whether (and, if not, why not) its audit committee includes at least one member who is a “financial expert.”364 On January 23, 2003, the SEC adopted the SOX 406/407 Release365 containing rules regarding audit committee financial experts to implement SOX § 407.366 The final rule uses the term “audit committee financial expert,” instead of the term “financial expert” used in SOX § 407 and an earlier proposed rule because the SEC believes the former term:

• “suggests more pointedly that the designated person [must have] characteristics that are particularly relevant to the functions of the audit committee. . . .”367 The rules

359 SOX §§ 406/407 Release, supra note 352, at 5119; see generally SOX § 406(b), supra note 350. 360 SOX §§ 406/407 Release, supra note 352, at 5119; see generally SOX § 406(b), supra note 350. 361 SOX §§ 406/407 Release, supra note 352, at 5119; see generally SOX § 406(b), supra note 350. 362 SOX §§ 406/407 Release, supra note 352, at 5119; see generally SOX § 406(b), supra note 350. 363 SOX §§ 406/407 Release, supra note 352, at 5119. 364 SOX § 407, 15 U.S.C.A. § 7265 (West Supp. 2007) [hereinafter SOX § 407]. 365 SOX §§ 406/407 Release, supra note 352. 366 SOX § 407 requires the SEC to adopt rules: (1) requiring a reporting company to disclose whether its audit

committee includes at least one member who is a “financial expert” and (2) defining the term “financial expert.” Id. at 5110.

367 SOX §§ 406/407 Release, supra note 352, at 5111; See Proposed Rule: Disclosure Required by Sections 404, 406–07 of the Sarbanes Oxley Act of 2002, Securities Act Release No. 8138, Exchange Act Release No. 46,701,


under SOX § 407 require reporting companies to disclose in their Form 10-K that:368

o its board of directors has determined that the company either: (i) has at least one “audit committee financial expert” serving on the company’s audit committee369 and the name of such person or (ii) does not have an audit committee financial expert serving on its audit committee and the reason it has no audit committee financial expert; and

o if the company discloses that it has at least one audit committee financial expert serving on its audit committee, the company must identify the audit committee financial expert by name and disclose whether that person is “independent,”370 and if not, an explanation.371

The rules under SOX § 407 define the term “audit committee financial expert” to mean a person who has all of the following attributes:

• An understanding of generally accepted accounting principles and financial statements;

• The ability to assess the general application of such principles in connection with the accounting for estimates, accruals and reserves;

• Experience preparing, auditing, analyzing, or evaluating financial statements that present a breadth and level of complexity of accounting issues that are generally comparable to the breadth and complexity of issues that can

Investment Company Act Release No. 25,775, 67 Fed. Reg. 66,208 (Oct. 30, 2002), available at http://www.sec.gov/rules/proposed/33-8138.htm.

368 SOX §§ 406/407 Release, supra note 352, at 5111. The rules discussed herein relating to annual reports of reporting companies on Form 10-K also contain similar provisions applicable to annual reports of small business reporting companies on Form 10-KSB. The SOX 406/407 Release also adopted rules with similar requirements for investment companies. The disclosure regarding audit committee financial experts is required only in Form 10-K annual reports and may be incorporated therein by reference from the issuer’s proxy statement. Disclosure Required by Sections 406 and 407 of the Sarbanes-Oxley Act of 2002, Securities Act Release No. 8177A, Exchange Act Release No. 47,235A, 68 Fed. Reg. 15,353 (Mar. 31, 2003), available at http://www.sec.gov/rules/final/33-8177A.htm.

369 SOX § 2(a), 15 U.S.C.A. § 7201 (West Supp. 2007) [hereinafter SOX § 2] defines the term “audit committee” as:

(A) a committee (or equivalent body) established by and amongst the board of directors of an issuer for the purpose of overseeing the accounting and financial reporting processes of the issuer and audits of the financial statements of the issuer; and

(B) if no such committee exists with respect to an issuer, the entire board of directors of the issuer. Id. 370 “Independence” for these purposes is defined in Item 7(d)(3)(iv) of Schedule 14A under the 1934 Act, which

makes reference to the definition of independence in the various listing standards of the NYSE, AMEX, and NASD. 17 C.F.R. § 228.401(e)(1)(ii) (2006); 17 C.F.R. § 229.401(h)(1)(ii) (2006).

371 SOX §§ 406/407 Release, supra note 352, at 5111; 17 C.F.R. § 228.401(h)(1)(iii) (2006); 17 C.F.R. § 229.401(e)(1)(iii) (2006).


reasonably be expected to be raised by the company’s financial statements, or experience actively supervising one or more persons engaged in such activities;

• An understanding of internal controls and procedures for financial reporting; and

• An understanding of audit committee functions.372

372 SOX §§ 406/407 Release, supra note 352, at 5113; SOX § 407, supra note 364. The rules initially proposed

under SOX § 407 would have used the term “financial expert” instead of “audit committee financial expert” and would have defined the term in a way that would have made it more difficult to obtain people with the requisite qualifications. As proposed initially, the term “financial expert” was defined as:

a person who [was] educat[ed] and experience[d] as a public accountant, auditor, principal financial officer, controller, or principal accounting officer of a company that [was a reporting company] at the time the person held such position. . . . [A “financial expert,” or a person having] experience in one or more positions that involve the performance of similar functions (or that results, in the judgment of the issuer’s board of directors, in the person’s having similar expertise and experience), [was required to possess] the following attributes:

(1) An understanding of generally accepted accounting principles and financial statements;

(2) Experience applying such generally accepted accounting principles in connection with the accounting for estimates, accruals, and reserves that are generally comparable to the estimates, accruals and reserves, if any, used in the issuer’s financial statements;

(3) Experience preparing or auditing financial statements that present accounting issues that are generally comparable to those raised by the issuer’s financial statements;

(4) Experience with internal controls and procedures for financial reporting; and

(5) An understanding of audit committee functions. SOX §§ 406/407 Release, supra note 352, at 5112. To be a financial expert under the first proposed definition, an individual would have had to possess all of the five specified attributes, and exposure to the rigors of preparing or auditing financial statements of a reporting company was very important. The board of directors, however, could have concluded that an individual possessed the required attributes without having the specified experience. If the board of directors made such a determination on the basis of alternative experience, the company would have had to disclose the basis for the board’s determination. In determining whether a potential financial expert has all of the requisite attributes, the proposed rules suggested the board of directors of an issuer should evaluate the totality of an individual’s education and experience and, among others, the following:

• The level of the person’s accounting or financial education, including whether the person has earned an advanced degree in finance or accounting;

• Whether the person is a certified public accountant, or the equivalent, in good standing, and the length of time that the person [has] actively . . . practiced as a certified public accountant, or the equivalent;

• Whether the person is certified or otherwise identified as having accounting or financial experience by a recognized private body that establishes and administers standards in respect of such expertise, whether the person is in good standing with the recognized private body, and the length of time that the person has been actively certified or identified as having such expertise;


Under the final SOX § 407 rules, a person must have acquired such attributes through any one or more of the following:

• Education and experience as a principal financial officer, principal accounting officer, controller, public accountant or auditor or experience in one or more positions that involve the performance of similar functions;

• Experience actively supervising a principal financial officer, principal accounting officer, controller, public accountant, auditor or person performing similar functions; or

• Whether the person has served as a principal financial officer, controller or principal accounting officer of a company that, at the time the person held such position, was required to file [periodic] reports pursuant to [the 1934 Act] . . . and if so, [the length of any such service];

• The person’s specific duties while serving as a public accountant, auditor, principal financial officer, controller, principal accounting officer or position involving the performance of similar functions;

• The person’s level of familiarity and experience with all applicable laws and regulations regarding the preparation of financial statements [required to] be included in [periodic] reports filed under [the 1934] Act;

• The level and amount of the person’s direct experience reviewing, preparing, auditing or analyzing financial statements [required to be] included in [periodic] reports filed under [the 1934] Act;

• The person’s past or current membership on one or more audit committees of companies that, at the time the person held such membership, were required to file reports pursuant to the [1934] Act;

• The person’s level of familiarity and experience with the use and analysis of financial statements of public companies; and

• Whether the person has any other relevant qualifications or experience that would assist him or her in understanding and evaluating the [issuer]’s financial statements and other financial information and [in] mak[ing] knowledgeable and thorough inquiries whether: — The financial statements fairly present the financial condition, results of

operations and cash flows of the company in accordance with generally accepted accounting principles; and

— The financial statements and other financial information, taken together, fairly present the financial condition, results of operations and cash flows of the company.

Id. at 5113. “The fact that a person previously had served on [the company’s audit committee would] not, by itself, [have let one] justify the board of directors in ‘grandfathering’ that person as a[] . . . financial expert under the [originally proposed rules,” and that concept is carried forward in the final rules. Id. The less restrictive definition of “audit committee financial expert” was adopted by the SEC in response to widespread comments that the originally proposed definition of “financial expert” was too restrictive. Id.


• Other relevant experience.373

In allowing a person to qualify as an audit committee financial expert by having “other relevant experience,” the SEC recognizes that an audit committee financial expert can acquire the requisite attributes of an expert in many different ways.374 The SEC states in the SOX 406/407 Release that it “believe[s] that this expertise should be the product of experience and not merely education.375 Under the final rules, if a person qualifies as an expert by virtue of possessing ‘other relevant experience,’ the company’s disclosure must briefly list that person’s experience.”376

The SEC also found that it would be adverse to the interests of investors if the designation and identification of the audit committee financial expert affected the duties, obligations or liabilities to which any member of the company’s audit committee or board is subject.377 To codify that position, the SEC included in the adopting release a new safe harbor which clarifies that:

• A person who is determined to be an audit committee financial expert will not be deemed an “expert” for any purpose, including without limitation for purposes of § 11 of the 1934 Act, as a result of being designated or identified as an audit committee financial expert by a company;

• The designation or identification of a person as an audit committee financial expert by a company does not impose on such person any duties, obligations or liabilities that are greater than the duties, obligations and liabilities imposed on such person as a member of the audit committee and board of directors in the absence of such designation and identification; and

• The designation or identification of a person as an audit committee financial expert by a company does not affect the duties, obligations or liabilities of any other member of the audit committee or board of directors.378

The safe harbor clarifies that any information in a registration statement reviewed by the audit committee financial expert is not “expertised” unless such person is acting in the capacity of some other type of traditionally recognized expert.379 Similarly, because the audit committee financial expert is not an expert for purposes of § 11 of the 1934 Act, he or she is not subject to a higher level of due diligence with respect to any portion of the registration statement as a result of his or her designation or identification as an audit committee financial

373 Id. (codified at 17 C.F.R. §§ 228.401, 229.401 (2006)). 374 Id. at 5116. 375 Id. 376 Id. 377 Id. 378 Id. at 5116–17. 379 Id. at 5117.


expert.380

SOX does not explicitly state who at the company should determine whether a person qualifies as an audit committee financial expert. The adopting release states that the SEC believes that the board of directors in its entirety, as the most broad-based body within the company, is best-equipped to make the determination.381 The SEC also views “it [as] appropriate that any such determination will be subject to relevant state law principles such as the business judgment rule.”382

The fact that a person previously has served on the company’s audit committee would not, by itself, justify the board of directors in “grandfathering” that person as an audit committee financial expert under the adopted rules.383

The proposed attributes of a “financial expert” described above are more detailed and rigorous than those reflected in the current NYSE, NASDAQ, AMEX, PCX, and other self-regulatory organization rules.384 Therefore, it is possible that a person who previously qualified as a financial expert under the current guidelines included in the rules of self-regulatory organizations may not have sufficient expertise to be considered a financial expert under these SEC rules. Therefore, it is important for reporting companies to re-evaluate whether an audit committee member who has the requisite level of financial expertise for purposes of the self-regulatory organizations also qualifies as a financial expert under the SEC rules.

Companies must comply with the audit committee financial expert disclosure requirements promulgated under SOX § 407 in their annual reports for fiscal years ending on or after July 15, 2003.385

H. Systematic SEC Review of 1934 Act Filings

SOX § 408 requires the SEC to review disclosures made by listed companies on a regular and systematic basis and to review disclosures made by a public company at least once every three years.386 In scheduling the required reviews, the SEC is expected to focus upon:

(1) “issuers that have issued material restatements of financial results;

(2) issuers that experience significant volatility in their stock price as compared to other issuers;

380 Id. (codified at 17 C.F.R. §§ 228.401(e)(4)(i), 229.401(h)(4)(i) (2006)). 381 Id. 382 Id. at 5113–17. 383 Id. at 5116. 384 17 C.F.R. §§ 228.401(e)(2)(i)–(v), 229.401(h)(2)(i)–(v) (2006). 385 SOX §§ 406/407 Release, supra note 352 at 5121; see SOX § 407, supra note 364. 386 SOX § 408, 15 U.S.C.A. § 7266 (West Supp. 2007) [hereinafter SOX § 408].


(3) issuers with the largest market capitalization;

(4) emerging companies with disparities in price to earning ratios; [and]

(5) issuers whose operations significantly affect any material sector of the economy[.]”387

I. Accelerated Disclosure in Plain English

The 1934 Act is amended by SOX § 409 to require reporting companies to “disclose to the public on a rapid and current basis such additional information concerning material changes in the financial condition or operations of the issuer, in plain English, which may include trend and qualitative information and graphic presentations,” as the SEC may by rule prescribe.388

Accordingly, the SEC has amended389 its “rules and forms to accelerate the filing of quarterly and annual reports under the [1934] Act by [larger] domestic reporting companies” so that the filing deadlines may be summarized as follows for an issuer’s fiscal years ending on or after December 15, 2005:390

Revised Deadlines For Filing Periodic Reports

Category of Filer Form 10-K Deadline Form 10-Q Deadline

Large Accelerated Filer ($700M or more)

75 days for fiscal years ending before December 15, 2006 and 60 days for fiscal years ending on or after December 15, 2006

40 days

Accelerated Filer ($75M or more and less than $700M)

75 days 40 days

Non-accelerated Filer (less than $75M)

90 days 45 days

The SEC also adopted amendments to require accelerated filers to disclose in their Form 10-K annual reports where investors can obtain access to their filings and whether the

387 SOX § 408(b), supra note 386. 388 SOX § 409, amending 15 U.S.C.A. § 78m (West Supp. 2007) (emphasis added). 389 Acceleration of Periodic Reporting Filing Dates and Disclosure Concerning Website Access to Reports,

Securities Act Release No. 8128, Exchange Act Release No. 46,464, 67 Fed. Reg. 58,480 (Sept. 16, 2002), available at http://www.sec.gov/rules/final/33-8128.htm. It should be noted that the SEC initially proposed these rules on April 12, 2002, which was prior to the enactment of SOX.

390 Securities Act Release No. 8128, supra note 389; Revisions to Accelerated Filer Definition and Accelerated Deadlines for Filing Periodic Reports, Securities Act Release No. 8644, Exchange Act Release No. 52,989, 70 Fed. Reg. 76,626 (Dec. 21, 2005), available at http://www.sec.gov/rules/final/33-8644.pdf.


company provides access to its Forms 10-K, 10-Q, and 8-K reports on its Internet website, free of charge. This is to be done “as soon as reasonably practicable after those reports are electronically filed with or furnished to the Commission.”391

VI. CORPORATE AND CRIMINAL FRAUD ACCOUNTABILITY (SOX TITLE VIII)

A. Records Retention

Title VIII of SOX is entitled the “Corporate and Criminal Fraud Accountability Act of 2002” and amends Federal criminal law to prohibit: (1) knowingly destroying, altering, concealing, or falsifying records with the intent to obstruct or influence an investigation in a matter in Federal jurisdiction or in bankruptcy (this offense is punishable by up to twenty years in prison)392 and (2) auditor failure to maintain for a five-year period all audit or review work papers pertaining to an issuer of securities.393 The SEC is directed to promulgate regulations regarding the retention of audit records containing conclusions, opinions, analyses, or financial data.394

On January 24, 2003 the SEC adopted rules that added § 210.2-06 to Regulation S-X (under “Qualifications and Reports of Accountants”),395 which “require[s] accountants who [review or] audit . . . an issuer’s financial statements to retain[, for seven years after the end of the completion of the audit or review,] certain [materials] relevant to the audit or review . . .[,] includ[ing] workpapers396 and other documents that form the basis of the audit or review . . . [of an issuer’s financial statements,] memoranda, correspondence, communications, other documents, and records (including electronic records) [that (1)] are created, sent or received in connection with the audit or review, and [(2)] contain conclusions, opinions, analyses, or financial data related to the audit or review.”397

“[N]on-substantive materials that are not part of the workpapers, such as administrative records, and other documents that do not contain relevant financial data or the auditor’s conclusions, opinions, or analyses would not meet the second of the criteria in [R]ule 2-06(a) and would not have to be retained. . . .”398 The release adopting Rule 2-06 indicates that “the following documents would [not] be considered substantive and [would not] have to be retained:

391 Securities Act Release No. 8128, supra note 389, at 58,481. 392 SOX § 802(a), 18 U.S.C.A. § 1519 (West Supp. 2007). 393 SOX § 802(b), 18 U.S.C.A. § 1520 (West Supp. 2007). 394 Id. 395 Retention of Records Relevant to Audits and Reviews, Securities Act Release No. 8180, Exchange Act

Release No. 47,241, 68 Fed. Reg. 4862 (Jan. 30, 2003) (codified in 17 C.F.R. § 210 (2006)), available at http://www.sec.gov/rules/final/33-8180.htm.

396 “Workpapers” are defined as “documentation of auditing or review procedures applied, evidence obtained, and conclusions reached by the accountant in the audit or review engagement, as required by standards established or adopted by the [SEC or the PCAOB].” Id. at 4864.

397 Id. at 4863. 398 Id.


• [s]uperseded drafts of memoranda, financial statements or regulatory filings;

• [n]otes on superseded drafts of memoranda, financial statements or regulatory filings that reflect incomplete or preliminary thinking;

• [p]revious copies of workpapers that have been corrected for typographical errors or errors due to training of new employees;

• [d]uplicates of documents, or

• [v]oice-mail messages.”399

However, “these records [would] . . . fall within the scope of new [R]ule 2-06 [to the extent] they . . . contain information or data, relating to a significant matter, that is inconsistent with the auditor’s final conclusions, opinions, or analyses on that matter or the audit or review.400 For example, [R]ule 2-06 would require the retention of an item in this list if that item documented a consultation or resolution of differences of professional judgment.”401

All of the issuer’s financial information, records, databases, and reports that the auditor examines on the issuer’s premises, but are not made part of the auditor’s workpapers or otherwise currently retained by the auditor, are not deemed to be “received” by the auditor under Rule 2-06(a)(1) and do not have to be retained by the auditor.402

Note that the PCAOB is directed in SOX § 103 to require auditors to retain, for a period of seven years, workpapers to support the auditor’s conclusions.403 Many documents may be subject to both retention requirements, though the SEC’s retention requirement applies to a broader range of documents that do not necessarily just support conclusions.404

B. Non-dischargeable Fraud Judgments

SOX § 803 amends Federal bankruptcy law to make non-dischargeable bankruptcy judgments and settlement agreements that result from a violation of Federal or State securities law, or common law, fraud pertaining to securities sales or purchases.405

C. Extension of Statute of Limitation for Securities Fraud Claims

SOX § 804 amends the Federal Judicial Code to permit a private right of action for a securities fraud claim to be brought not later than the earlier of: (1) five years after the date of

399 Id. 400 Id. 401 Id. 402 Id. 403 SOX § 103(a)(2)(A)(i), 15 U.S.C.A. § 7213(a)(2)(A)(i) (West Supp. 2007). 404 Securities Act Release No. 8180, supra note 395, at 4862–64; see 17 C.F.R. § 210.2-06 (2006). 405 SOX § 803, amending 11 U.S.C.A. § 523 (West Supp. 2007).


the alleged violation or (2) two years after its discovery.406

D. Sentencing Guidelines

SOX § 805 directed the U.S. Sentencing Commission to review and amend federal sentencing guidelines to ensure that the offense levels, existing enhancements, or offense characteristics are sufficient to deter and punish violations involving: (1) obstruction of justice; (2) record destruction; (3) fraud when either the number of victims adversely involved is significantly greater than 50 or when it endangers the solvency or financial security of a substantial number of victims; and (4) organizational criminal misconduct.407

E. Whistleblower Protection

Under SOX § 806, whistleblower protection is extended to individuals who report (to particular federal agencies, to Congress, or to a supervisor) conduct the individual reasonably believes constitutes a violation of: (a) the federal securities laws; (b) SEC rules; or (c) any provision of federal law relating to fraud against shareholders.408 SOX § 806 forbids a public company and its officers, employees, contractors, subcontractors, and agents from discharging, demoting, suspending, threatening, harassing, or in any way discriminating against an employee because the employee provided information or assisted in an investigation the employee reasonably believed constituted a violation of SOX, any rule or regulation of the SEC, or any provision of federal law relating to fraud against shareholders.409

Furthermore, SOX § 806 protects a whistleblower even if his or her report of wrongdoing is incorrect, provided the whistleblower reasonably believed that what he or she reported constituted a violation.410 This means a company can prove that a complainant’s understanding of an SEC rule was mistaken, and the allegation thus unwarranted, and yet still lose a SOX whistleblower case.

Employees are also protected if they file, cause to be filed, testify in, participate in, or otherwise assist in a proceeding filed (or about to be filed) relating to any rule or regulation of the SEC or any provision of federal law relating to fraud against shareholders.411 This means that employees are insulated from retaliation for testifying or participating in class action securities litigation, for example. Employers (and in some cases individuals) found to have retaliated against a whistleblower may be subject to administrative, civil, and criminal sanctions.412

406 SOX § 804, amending 28 U.S.C.A. § 1658 (West Supp. 2007). See Jeffrey Q. Smith & James K. Goldfarb,

Circuit Courts Foreclose Retroactive Application of SOXA’s New Statute of Limitations for Federal Securities Law Claims, 37 Sec. Reg. & L. Rep. (BNA) 236 (Feb. 7, 2005).

407 SOX § 805 (ordering review pursuant to 28 U.S.C.A. § 994 (West Supp. 2007)). 408 SOX § 806(a), 18 U.S.C.A. § 1514A (West Supp. 2007); see 29 C.F.R. § 1980 (2006). 409 SOX § 806(a), 18 U.S.C.A. § 1514A (West Supp. 2007); see 29 C.F.R. § 1980 (2006). 410 SOX § 806(a), 18 U.S.C.A. § 1514A (West Supp. 2007); see 29 C.F.R. § 1980 (2006). 411 SOX § 806(a), 18 U.S.C.A. § 1514A (West Supp. 2007); see 29 C.F.R. § 1980 (2006). 412 See SOX § 806(a), 18 U.S.C.A. § 1514A (West Supp. 2007); see 29 C.F.R. § 1980 (2006).


F. Enhanced Fraud Penalties

SOX § 807 subjects any person who defrauds shareholders of publicly traded companies to a fine and imprisonment for up to twenty-five years.413

VII. MISLEADING STATEMENTS TO AUDITORS

A. SOX § 303 Requirements

SOX § 303 makes it “unlawful, in contravention of . . . rules [adopted by the SEC], for any officer or director of an issuer, or any other person acting under the direction thereof, to take any action to fraudulently influence, coerce, manipulate, or mislead any independent public or certified accountant engaged in the performance of an audit of the financial statements of that issuer for the purpose of rendering such financial statements materially misleading.”414 On May 20, 2003, the SEC amended and expanded Rule 13b2-2415 under the 1934 Act (which already prohibited the falsification of books, records and accounts, and false or misleading statements, or omissions to make certain statements, to accountants) by adding (x) a new subsection (b)(1) that specifically prohibits officers and directors and “persons acting under [their] direction,”416 from coercing, manipulating, misleading, or fraudulently

413 SOX § 807(a), 18 U.S.C.A. § 1348 (West Supp. 2007). 414 Improper Influence on Conduct of Audits, Exchange Act Release No. 47,890, Investment Company Act

Release No. 26,050, 68 Fed. Reg. 31,820, 31,820 (May 20, 2003), available at http://www.sec.gov/rules/final/34-47890.htm.

415 Id. 416 In adopting Release No. 34-47890 (May 20, 2003), the SEC commented:

[N]ew rule 13b2-2(b)(1) covers the activities of not only officers and directors of the issuer who engage in an attempt to misstate financial statements but also “any other person acting under the direction thereof.” Activities by such “other persons” currently may constitute violations of the anti-fraud or other provisions of the securities laws or aiding or abetting or causing an issuer’s violations of the securities laws. Section 303(a) and the new rule provide the Commission with an additional means of addressing efforts by persons acting under the direction of an officer or director to improperly influence the audit process and the accuracy of the issuer’s financial statements.

As noted in the proposing release, we interpret Congress’ use of the term “direction” to encompass a broader category of behavior than “supervision.” In other words, someone may be “acting under the direction” of an officer or director even if they are not under the supervision or control of that officer or director. Such persons might include not only the issuer’s employees but also, for example, customers, vendors or creditors who, under the direction of an officer or director, provide false or misleading confirmations or other false or misleading information to auditors, or who enter into “side agreements” that enable the issuer to mislead the auditor. In appropriate circumstances, persons acting under the direction of officers and directors also may include not only lower level employees of the issuer but also other partners or employees of the accounting firm (such as consultants or forensic accounting specialists retained by counsel for the issuer) and attorneys, securities professionals, or other advisers who, for example, pressure an auditor to limit the scope of the audit, to issue an unqualified report on the financial statements when such a report would be unwarranted, to not object to an inappropriate accounting treatment, or not to withdraw an issued audit report on the issuer’s financial statements.

. . .

Some commenters were concerned that including customers, vendors and creditors in the discussion of those persons who, in appropriate circumstances, might be considered to be acting under the direction of an officer or director would have a chilling effect on communications between those


influencing (collectively referred to herein as “improperly influencing”) an auditor “engaged in the performance of an audit”417 of the issuer’s financial statements when the officer, director, or other person “knew or should have known”418 that the action, if successful, could result in rendering the issuer’s financial statements filed with the SEC materially misleading and (y) a new subsection (b)(2) that provides examples of actions that improperly influence an auditor that could result in “rendering the issuer’s financial statements materially misleading.”419

Types of conduct that the SEC suggests could constitute “improperly influencing” “include, but are not limited to, directly or indirectly:

persons and the auditors. Other commenters noted that this chilling effect would be enhanced by the Commission's position in the proposing release that negligently misleading the auditor was sufficient conduct to trigger application of the rule. . . . We believe that third parties providing information or analyses to an auditor should exercise reasonable attention and care in those communications. A primary purpose for enactment of the Sarbanes-Oxley Act is the restoration of investor confidence in the integrity of financial reports, which will require the cooperation of all parties involved in the audit process. We do not intend to hold any party accountable for honest and reasonable mistakes or to sanction those who actively debate accounting or auditing issues. We do believe, however, that those third parties who, under the direction of an issuer’s officers or directors, mislead or otherwise improperly influence auditors when they know or should know that their conduct could result in investors being provided with misleading financial statements or a misleading audit report, should be subject to sanction by the Commission.

Exchange Act Release No. 47,890, supra note 414, at 31,821–22 (emphasis added). 417 Amended Rule 13b2-2’s applicability is not limited to the formal engagement period of the issuer’s current

outside auditor. In adopting Release No. 34-47890 (May 20, 2003), the SEC commented that:

[t]he phrase “engaged in the performance of an audit” should be given a broad reading [and] . . . encompass the professional engagement period and any other time the auditor is called upon to make decisions or judgments regarding the issuer’s financial statements, including during negotiations for retention of the auditor and subsequent to the professional engagement period when the auditor is considering whether to issue a consent on the use of prior years’ audit reports.

Id. at 31,825. 418 Amended Rule 13b2-2 can be violated without any specific intent to render the issuer’s financial statements

materially misleading and without the prohibited action achieving its desired end or actually resulting in misleading financial statements. In adopting Release No. 34-47890 (May 20, 2003), the SEC commented that:

[t]he phrase “knew or should have known,” . . . historically has indicated the existence of a negligence standard . . . [which] is consistent with the Commission’s enforcement actions in this area [and] . . . particularly in the absence of any private right of action under the rule, best achieves the purpose of restoring investor confidence in the audit process.

Exchange Act Release No. 47,890, supra note 414, at 31,826. Amended Rule 13b2-2 departs from the text of SOX § 303 by using “knew or should have known,” a negligence standard, in place of the statutory “for the purpose of” language, which would require specific intent. Thus, the SEC will not be required to show that a person’s actions were intended to render the issuer’s financial statements materially misleading, but only that the person knew or was negligent in not knowing that his or her actions could achieve that result. The distinction is illustrated by an example in the adopting release:

For example, if an officer of an issuer coerces an auditor not to conduct certain audit procedures required by generally accepted auditing standards (“GAAS”) because the officer wants to conceal his embezzlement of funds from the issuer, then it is possible that his actions might not be found to be for the “purpose of rendering the financial statements misleading.” If that officer, however, knew or should have known that not performing the procedures could result in the auditor not detecting and seeking correction of material errors in the financial statements, then we believe the officer’s conduct should be subject to the rule.

Id. 419 Id. at 31,820.


• Offering or paying bribes or other financial incentives, including offering future employment or contracts for non-audit services,

• Providing an auditor with inaccurate or misleading legal analysis,

• Threatening to cancel or canceling existing non-audit or audit engagements if the auditor objects to the issuer’s accounting,

• Seeking to have a partner removed from the audit engagement because the partner objects to the issuer’s accounting,

• Blackmailing, and

• Making physical threats.”

Rule 13b2-2 applies throughout the professional engagement and after the professional engagement has ended when the auditor is considering whether to consent to the use of, reissue, or withdraw prior audit reports.

Conducting reviews of interim financial statements and issuing consents to use past audit reports are within the scope of Rule 13b2-2.420

B. Enforcement

SOX § 303(b) provides the SEC with sole civil enforcement authority with respect to SOX § 303 and any rule or regulation issued under SOX § 303, thereby precluding a private right of action. While there is no private right of action for violations of SOX § 303 and related SEC rules, persons providing misleading information to auditors could have liability therefore under common law causes of action such as negligent misrepresentation.421

420 Id. at 31,823–25 (emphasis added). 421 Compare Dean Foods Co. v. Pappathanasi, in which a $9 million judgment was rendered by a trial court after

a non-jury trial against a law firm for negligent misrepresentation as a result of the failure to disclose in a closing opinion for an acquisition certain information which it had regarding a government subpoena of documents regarding a customer's alleged tax fraud. 18 Mass. 598, (Mass. Sup. Ct. 2004). The defendant law firm had opined to the acquiring company, as counsel to the acquired company, to the acquiring company that “to the firm’s knowledge, without investigation, except as disclosed in a schedule to the acquisition agreement: (a) there was no investigation of any kind pending or threatened against the Company and (b) the Company was not ‘subject to any . . . continuing’ governmental investigation.” Id. The law firm had assisted the acquired company in responding to the government’s subpoena, had looked into whether the acquired company had aided the fraud, but guessed that the investigation had probably gone away with the customer making payments to the government. The law firm advised the acquired company that the matter did not require disclosure in a schedule to the acquisition agreement. Three months after the closing, the acquired company received a “target letter” from the government. Id. Ultimately the acquired company pled guilty to aiding and abetting tax fraud, and paid a fine of $7.2 million. The purchaser sued the acquired company’s law firm which had rendered the opinion that no proceedings were pending or threatened against the acquired company. The court concluded that the law firm had enough notice that it could not rely on the acquired company’s representations and had a duty to investigate, which it did not do adequately. The law firm ended up


Both before and after the May 20, 2003 amendment to 1934 Act Rule 13b2-2, the SEC was bringing enforcement actions against individuals (including inside counsel) for their roles in the falsification of accounting records and misleading statements to accountants, some of which predated the enactment of SOX. The following actions are examples of this.

Rite Aid. In United States v. Grass, and SEC v. Bergonzi, the Department of Justice and the SEC brought criminal and civil charges respectively against three senior executives of Rite Aid Corporation.422 The executives (the chief executive officer, chief financial officer, and the vice chairman/chief legal officer) were accused of utilizing various schemes to inflate Rite Aid’s revenues and net income every quarter over a two year period, thereby increasing their performance based bonuses and other compensation, and, in furtherance of those schemes, directing Rite Aid’s accounting staff to enter false or misleading accounting entries which were subsequently included in Rite Aid’s public filings, registration statements and other documents related to offerings of securities. Among the violations alleged in the SEC’s complaint were: (i) deducting from amounts owed vendors inflated and unsupported allowances for damaged and outdated products that were not authorized by agreements, (ii) classifying vendor rebates that were contingent on future sales as reductions to accounts payable, (iii) prematurely recognizing income from a litigation settlement before the settlement agreement was signed, (iv) failing to disclose the CEO’s personal interest in three properties which the company leased as store locations, (v) falsifying board committee minutes, (vi) making misrepresentations to lenders, and (vii) signing management representation letters to auditors that contained false statements.423 Unraveling these schemes resulted in Rite Aid restating cumulative pretax income by $2.3 billion and cumulative net income by $1.6 billion.424

All three officers either pled guilty or were found guilty of criminal charges brought against them and received prison sentences ranging from twenty-eight months to ten years.425 The SEC’s civil actions against the officers were stayed during the pendency of the criminal actions and were settled subsequent to the criminal convictions with monetary penalties and injunctive relief. Rite Aid Corporation itself settled SEC charges by agreeing to a cease and

settling the case. See Donald W. Glazer & Arthur Norman Field, No-litigation Opinions Can Be Risky Business: Looking at the Facts—and Beyond, 14 BUSINESS LAW TODAY No. 6 (July/Aug. 2005), at 37. An attorney could also have liability exposure under other provisions of federal or state securities laws. Cf. Memorandum and Order Re Secondary Actors’ Motion to Dismiss filed December 20, 2002 in In re Enron Corp. Sec., Derivative and ERISA Litig., 235 F. Supp. 2d 549 (S.D. Tex. 2002), (also known as Newby v. Enron or the Newby case) (the opinion is 159 pages long).

422 See Bergonzi, 77 SEC Docket 3003 (June 21, 2002), available at http://www.sec.gov/litigation/litreleases/lr17577.htm; Accord Press Release, SEC Announces Fraud Charges Against Former Rite Aid Senior Management, (June 21, 2002), available at http://www.sec.gov/news/press/2002-92.htm.

423 See Complaint, SEC v. Bergonzi, No. 1:CV02-1084 (M.D. Pa. June 20, 2002), available at http://www. sec.gov/litigation/complaints/complr17577.htm.

424 Bergonzi, 77 SEC Docket 3003 (June 21, 2002), available at http://www.sec.gov/litigation/litreleases/lr17577.

425 See Bergonzi, 82 SEC Docket 3327 (May 26, 2004), available at http://www.sec.gov/litigation/litreleases/lr18727.htm; Bergonzi, 82 SEC Docket 3327 (May 27, 2004), available at http://www.sec.gov/litigation/litreleases/lr18728.htm; Bergonzi (Sept. 30, 2005), available at http://www.sec.gov/litigation/litreleases/lr19409.htm.


desist order.

Computer Associates. In United States. v. Kumar, securities fraud charges were brought by the Department of Justice and the SEC against Computer Associates International, Inc. (“CA”) and three of the company’s former top executives—Sanjay Kumar, former CEO and Chairman, Stephen Richards, former Head of Sales, and Steven Woghin, former General Counsel, alleging that from 1998 to 2000, CA routinely kept its books open to record revenue from contracts executed after the quarter ended in order to meet Wall Street quarterly earnings estimates and obstructed the SEC’s investigation into CA’s accounting practices.426

In settlements with the SEC and the Justice Department, CA agreed to pay $225 million in restitution to shareholders and to make reforms to its corporate governance and financial accounting controls.427 General Counsel Woghin pled guilty and agreed in a partial settlement to a permanent injunction and officer and director bar with monetary sanctions to be decided at a later point.428

The SEC’s complaints in the CA cases filed in the United States District Court for the Eastern District of New York allege, among other things:

• The defendants manipulated CA’s quarter end cutoff to align CA’s reported financial results with market expectations, and

• CA prematurely recognized revenue from software contracts that CA, its customer, or both parties, had not yet executed, in violation of GAAP.

• CA executives, including defendants Kumar, Richards, and Woghin, held CA’s books open for several days after the end of each quarter to improperly record in that quarter revenue from contracts that were not executed by customers or CA until several days or more after the expiration of the quarter.429 (In a Superseding Indictment filed in the E.D.N.Y. in United States v. Kumar on June 30, 2005, the United States alleged that this practice was referred to within CA as the “35-day month” or the “three-day window.” As a result of this improper practice, CA made material misrepresentations and omissions about its revenue and earnings in SEC filings and other public statements.)

• Woghin: (1) signed an SEC filing that contained materially false and misleading information regarding CA’s revenues and earnings per share; (2) approved backdated contracts, including drafting a contract with misleading dates; and (3) allowed CA’s Legal Department to approve contracts obtained by the sales force

426 See Press Release, U.S. Department of Justice, Enforcement Proceedings: In re Woghin, (Nov. 12, 2004),

available at http://www.sec.gov/news/digest/dig111204.txt. 427 Computer Assocs. Int’l, Inc., 83 SEC Docket 2462 (Sept. 22, 2004), available at

http://www.sec.gov/litigation/litreleases/lr18891.htm. 428 See Press Release, U.S. Department of Justice, supra note 426. 429 Computer Assocs. Int’l, Inc., 83 SEC Docket 2462, supra note 427, at *1–2.


while knowing, or recklessly disregarding the fact that, those contracts contained false and misleading signature dates and that CA would recognize revenue from those contracts in the incorrect fiscal quarter.

• Woghin encouraged several CA employees to make false and misleading statements to the SEC or CA’s outside counsel.430

Isselmann. In re Isselmann431 resulted in a consent cease and desist order being entered against John E. Isselmann, the General Counsel of Electro Scientific Industries, Inc. (“ESI”), whose “failure to fulfill his gatekeeper role was a cause of the Company reporting materially [false] financial results for” a quarter.432 His failure was to timely advise ESI’s Audit Committee and auditors that he had received an opinion of local foreign counsel that ESI could not eliminate benefits to its Asian employees where the benefits termination allowed ESI to report a profit rather than a loss and resulted in improper financial reporting in its Form 10-Q Report.

The facts were that ESI’s Chief Financial Officer (“CFO”) and Controller, without involving or consulting Isselmann, elected to terminate a retirement plan for ESI’s employees in Asia and reverse an accrual for pension benefits. During an Audit Committee meeting two weeks before the close of the quarter, the CFO advised “that the Japanese benefits were not legally required and that the decision . . . had been approved by legal counsel,” and “Isselmann identified ESI’s legal counsel in Japan, causing an Audit Committee member to believe that outside counsel had reviewed the decision.”433 Isselmann’s downfall at this stage was not speaking up because he knew that he, as General Counsel, had not “sought any outside legal review of the issue.”434 Three days after the end of the quarter, Isselmann sought legal advice of counsel in Japan. When the Japanese opinion was received four days later, it indicated that the pension benefits could not be eliminated unilaterally. Isselmann tried to raise the point at meetings with ESI’s Audit Committee, Disclosure Committee, and auditors prior to filing ESI’s Form 10-Q, but he was cut off by the CFO, who signed the Form 10-Q Report. Five months after the foregoing events occurred, the CFO had been promoted to CEO, and the new CFO told Isselmann for the first time exactly what had occurred with regard to the earlier accrual reversal. Isselmann immediately advised ESI’s Audit Committee and outside counsel, but the SEC concluded that his actions were “too little-too late.” While there is no allegation that Isselmann in any way participated in the scheme to falsify ESI’s numbers, the SEC found that Isselmann’s failure to timely disclose the Japanese legal opinion to the Audit Committee, the Board of Directors, and outside auditors “allowed the CFO and Controller to hide an ongoing fraud.”435 For their part the CFO and Controller were indicted on seventeen counts of financial fraud and falsifying records.

430 Id. at *2–3. 431 Isselmann, Exchange Act Release No. 50,428, 83 SEC Docket 2413 (Sept. 23, 2004), available at

http://www.sec.gov/litigation/admin/34-50428.htm. 432 Id. at *1. 433 Id. at *2. 434 Id. 435 Id. at *1.


Orlick/Gemstar-TV Guide. In Orlick,436 the SEC announced settlement of an enforcement action against Jonathan B. Orlick, the former Executive Vice President, General Counsel, Secretary, and a director of Gemstar-TV Guide International, Inc., a media and technology company that publishes TV Guide and develops, licenses, and markets an interactive program guide (“IPG”) for televisions which it touted as the “value driver” of the company’s stock. According to the SEC, during the period from June 1999 through September 2002, Gemstar overstated its total revenues by at least $248 million to meet growth projections for IPG licensing and advertising, and the SEC alleged that Orlick knew that the company was improperly recognizing and reporting licensing revenue. It was also alleged that Orlick repeatedly signed false representation letters to the company’s outside auditors regarding the status of negotiations with another company regarding a material licensing agreement. As part of the settlement, Orlick was enjoined from violating, or aiding and abetting violations, of securities laws, and was ordered to pay $305,511 in disgorgement of a prior bonus, interest, and a civil penalty. In addition, Orlick may not serve as an officer or director of a public company for a period of ten years, and has been suspended from appearing or practicing before the SEC. Orlick consented to the penalties, but neither admitted or denied liability.

Fitzhenry. In re Fitzhenry437 involved an SEC enforcement action against James A. Fitzhenry, Senior Vice President, General Counsel, and Secretary for FLIR Systems, Inc. (“FLIR”). At year-end 1998, FLIR improperly recognized $4.1 million in revenue from two purported sales to one of FLIR’s independent sales representatives in Columbia, based upon non-binding letters of intent. As part of the 1998 year-end audit of FLIR’s financial statements, FLIR’s outside auditors, PricewaterhouseCoopers LLP (“PwC”), selected these sales for testing and sent an accounts receivable confirmation, which the sales representative refused to return. In February 1999, Fitzhenry attempted to obtain a binding and unconditional agreement from FLIR’s independent sales representative to purchase the units stated in the non-binding letters of intent. The sales representative refused to provide an agreement of the type requested by Fitzhenry. From Fitzhenry’s negotiations with FLIR’s independent sales representative, he understood that the $4.1 million in sales were conditional in nature because the sales representative had no obligation to purchase the units. On April 12, 1999 and April 20, 1999, Fitzhenry signed two management representation letters to PwC, in connection with FLIR’s 1998 year-end audit. Among other things, both letters confirmed that: (1) risk of ownership for the units had passed to FLIR’s independent sales representative; and (2) the independent sales representative had made a fixed commitment to purchase the goods. Fitzhenry never told PwC about his negotiations with the independent sales representative, nor did he tell PwC that he understood the transactions were “conditional” in nature. Consequently, Fitzhenry made material misrepresentations and omitted material information in the management representation letters.

As a result of the conduct described above, [the SEC found that] Fitzhenry willfully violated pre-SOX Rule 13b2-2. In the settlement, Fitzhenry was denied the privilege of

436 Orlick, Exchange Act Release No. 51,081, 84 SEC Docket 2560 (Jan. 26, 2005), available at

http://www.sec.gov/litigation/admin/34-51081.htm. 437 Fitzhenry, Exchange Act Release No. 46,870 (Nov. 21, 2002), available at

http://www.sec.gov/litigation/admin/34-46870.htm.


appearing or practicing before the SEC as an attorney for five years.438

Steckler. In SEC v. Steckler, the SEC charged a vice president of sales of a subsidiary of a public company with aiding and abetting a supplier of his employer in improperly recognizing revenue in violation of Rules 10b-5 and 13b2-1 under the 1934 Act by arranging for an undisclosed side letter that made an otherwise unconditional order by his employer for the purchase of software provided to the supplier’s legal and accounting departments subject to cancellation.439 The SEC’s Complaint stated that under GAAP the side letter made the sale a contingent sale, which should not be recognized as revenue, and that the defendant concealed the side letter from the supplier’s legal and accounting departments, thereby causing the improper revenue recognition by the supplier.440

Google. In re Google, Inc.,441 the general counsel of Google consented to a cease and desist order as a result of giving erroneous advice to Google regarding the availability of an exemption from 1933 Act registration for the grant of employee stock options. In 2003, Google was a privately held company whose financial statements were confidential. Google believed that disclosing these financial statements would be “strategically disadvantageous,” and that making the financial statements widely available among Google employees could result in loss of information confidentiality that was essential at that stage in its business.442 At this time, Google was considering issuing stock options to its employees without registering the securities, but Rule 701 under the 1933 Act provided an exemption for the issuance of only $5 million in options over a 12-month period without providing detailed financial statements and other disclosures to the option recipients. When contemplating the first of these options grants in 2003, the general counsel consulted with outside counsel and his legal department colleagues at Google, and concluded that the $5 million threshold of the Rule 701 exemption would not likely be exceeded. Even if it were, he believed that exemptions under SEC Regulation D and 1933 Act § 4(2) might apply to allow Google to issue the options without registering the securities or transmitting detailed financial information to the option recipients, and “even if it were later determined that his analysis of the applicability of other registration exemptions was incorrect, Google could make an offer of rescission to the option holders.”443 Ultimately, Google issued approximately $49 million worth of stock options during 2003 and an additional $33 million worth during the first four months of 2004, prior to the filing of its registration statement for an initial public offering (“IPO”), without the general counsel explaining to Google’s board of directors that Rule 701 had not been complied with and the risks of reliance on another exemption from registration. The SEC ultimately concluded that there was no exemption from registration as all of the optionees did not have the requisite sophistication or receive the requisite information about Google. In August 2004 before its

438 Id. at *1–2. 439 Steckler, SEC Litigation Release No. 18,327, 81 SEC Docket 151 (Sept. 8, 2003), available at

http://www.sec.gov/litigation/litreleases/lr18327.htm; Complaint, SEC v. Steckler, (N.D. Cal. Sept. 8, 2003), available at http://www.sec.gov/litigation/complaints/comp18327.htm.

440 Complaint, SEC v. Steckler, supra note 439. 441 Google, Inc., Securities Act Release No. 8523, 84 SEC Docket 2293 (Jan. 13, 2005), available at

http://www.sec.gov/litigation/admin/33-8523.htm. 442 Id. 443 Id.


IPO, Google did offer rescission to the option holders, an offer that went unanswered due to the anticipated success of the IPO (the option exercise prices were less than $4 and the IPO price was expected to be over $100). By bringing this case, the Commission sent a reminder that a “technical violation” is a violation even if no economic harm occurs (i.e., there is no “good deal defense” to SEC enforcement actions).

FFP. In FFP Mktg. Co.,444 a general counsel was sanctioned for signing a misleading Form 12b-25 stating why the company could not file its Form 10-K Report within the prescribed time period. The Form 12b-25 failed to disclose that the auditors could not complete their audit because of an ongoing study into accounting irregularities that ultimately resulted in a significant write down of credit card receivables and a restatement of FFP’s financial statements.

Biopure Corporation. In SEC v. Biopure Corp.,445 Biopure Corporation and its general counsel consented to final judgments in a previously-filed action446 that (i) permanently enjoins Biopure from violating antifraud provisions of the federal securities laws and requires the company to retain an independent consultant to review Biopure’s disclosure, compliance and other policies and procedures and (ii) permanently enjoins the general counsel from aiding and abetting violations of the reporting provisions of the federal securities laws and orders her to pay a $40,000 civil penalty. The SEC’s Complaint alleged that Biopure received negative information from the FDA regarding its efforts to obtain FDA approval of its synthetic blood product, but failed to disclose the information, or falsely described it as positive developments.447 Biopure’s chief executive officer and its regulatory affairs head were separately charged.

C. False Confirmations

On November 2, 2005, the SEC charged seven individuals with providing false confirmations to the outside auditors of U.S. Foodservice, Inc., a subsidiary of Royal Ahold.448 Each defendant was an employee of a supplier to a subsidiary of Royal Ahold and was also the subject of criminal conspiracy charges filed by the U.S. Attorney’s Office for the Southern District of New York. Similar charges previously had been filed against nine others, and on June 7, 2006 civil charges were filed and settled against the owner/operator of several suppliers which had provided false confirmations to the subsidiary’s auditors,449 bringing the total number of third-party defendants in the matter to seventeen. Royal Ahold itself settled a related SEC proceeding in October 2004.

444 FFP Mktg. Co., Exchange Act Release No. 51,198, 84 SEC Docket 2981 (Feb. 14, 2005), available at

http://www.sec.gov/litigation/admin/34-51198.htm. 445 SEC Settles Civil Injunctive Action Against Biopure Corporation and Its General Counsel (Sept. 12, 2006),

http://www.sec.gov/litigation/litreleases/2006/lr19825.htm. 446 SEC Charges Massachusetts Biotechnology Company and Executives with Securities Fraud, 86 SEC Docket

599 (Sept. 14, 2005), available at http://www.sec.gov/litigation/litreleases/lr19376.htm. 447 SEC Settles Civil Injunctive Action Against Biopure Corporation and Its General Counsel, at *1 (Sept. 12,

2006), http://www.sec.gov/litigation/litreleases/2006/lr19825.htm. 448 Cowley (Nov. 2, 2005), http://www.sec.gov/litigation/litreleases/lr19454.htm. 449 Schoefield (June 7, 2006), http://www.sec.gov/litigation/litreleases/2006/lr19721.htm.


Industry practice was for such vendors to provide the Ahold subsidiary and other wholesale food distributors with sales rebates, referred to as “promotional allowances.” The Government alleged that, between 2000 and 2003, the Ahold subsidiary’s executives inflated the allowances paid by the vendors, and owed at year-end, by millions of dollars in the subsidiary’s financial statements. The executives also allegedly “induced” the Ahold subsidiary’s vendors to provide false confirmations of these amounts to Royal Ahold’s auditors. The implication was that, had the vendors not gone along with the scheme, the subsidiary’s officers would have steered business elsewhere.

This fact pattern is similar to prior cases in which the SEC has charged third parties who provided false confirmations to another company’s auditors with aiding and abetting securities fraud.450 What is significant in the Royal Ahold proceedings, however, is the number of third-party defendants who were charged. The majority of the defendants in the Royal Ahold proceedings were not employees of SEC registrants, but instead were owners or employees of private food distributors that did business with the Ahold subsidiary. The proceedings demonstrate that the SEC is prepared to bring charges against persons or entities not otherwise subject to SEC oversight, if their conduct interferes with the ability of a public company’s auditors to conduct a fair examination of the company’s financial statements.451

The SEC did not rely on amended Rule 13b2-2 in the Royal Ahold proceedings as most of the conduct predated the effective date of the revised rule. In the future, however, the SEC may bring cases under Rule 13b2-2 against third parties for providing “misleading” confirmations to another company’s auditors, even if they did not conspire with issuer officials or know that their confirmations were inaccurate. Should this occur, questions likely will arise as to whether the party furnishing the confirmation was acting “under the direction” of an officer or director of the issuer, as required to establish a Rule 13b2-2 violation, simply because he or she provided a confirmation at the request of an issuer officer.

D. Internal Investigations

Internal investigations into allegations of wrongdoing by corporate representatives are being conducted with increasing frequency by counsel retained by boards of directors or audit

450 See Kemps LLC, Securities Act Release No. 8485, Exchange Act Release No. 50,369, 83 SEC Docket 2204

(Sept. 14, 2004), available at http://www.sec.gov/litigation/admin/33-8485.pdf; Adams, Securities Act Release No. 8484, Exchange Act Release No. 50,367, 83 SEC Docket 2202 (Sept. 14, 2004), available at http://www.sec.gov/litigation/admin/33-8484.pdf; Digital Exch. Sys., Inc., Securities Act Release No. 8483, Exchange Act Release No. 50,366, 83 SEC Docket 2200 (Sept. 14, 2004), available at http://www.sec.gov/litigation/admin/33-8483.pdf.

451 See Scientific-Atlanta, Inc., 88 SEC Docket 831 (S.D.N.Y. June 22, 2006), available at http://www.sec.gov/litigation/litreleases/2006/lr19735.htm (suing vendor that supplied set-top boxes for use in Adelphia Communications’ cable business for aiding and abetting Adelphia’s reporting, books and records, and internal controls violations by entering into marketing support arrangements pursuant to which Scientific-Atlanta made marketing-support payments to Adelphia that were offset by price increases on equipment it sold to Adelphia, which enabled Adelphia to reduce its ordinary marketing expense and book the offsetting additional equipment costs as capital expenditures); Accord Brian A. Ochs, Has the Securities and Exchange Commission Expanded Corporate Liability?, 38 Sec. Reg. & L. Rep. (BNA) No. 37, 1549 (2006).


committees.452 The results of an internal investigation conducted by counsel are frequently furnished to the company’s auditors. As a result, counsel conducting such an investigation in some circumstances could have a duty under Rule 13b2-2 to conduct the investigation with sufficient thoroughness that the results do not mislead the auditors. When he was Director of the SEC Division of Enforcement, Stephen Cutler commented:

One area of particular focus for us is the role of lawyers in internal investigations of their clients or companies. We are concerned that, in some instances, lawyers may have conducted investigations in such a manner as to help hide ongoing fraud, or may have taken actions to actively obstruct such investigations.453

The DOJ is taking the position that lying to issuer counsel conducting an internal investigation is equivalent to lying to a prosecutor, law enforcement officer, or regulator about a crime, and exposes the liar to federal obstruction of justice charges.454 The DOJ has indicted under 18 U.S.C. § 1512(c), added by SOX Title XI,455 two former officers of Computer Associates International Inc. in respect of allegedly false statements made to issuer counsel during an internal investigation at that company.456 Charges under 18 U.S.C. § 1512(c), added by SOX Title XI, were also brought against an employee of El Paso Corp. based on statements made to outside counsel during an internal investigation.457

E. Relationship of SOX § 303 Requirements to 1934 Act § 10A

A violation of Rule 13b2-2 is an “illegal act” within the meaning of § 10A(b) of the 1934 Act and, therefore, must be reported by auditors under that section. Attorneys also should be aware that evidence of a violation of Rule 13b2-2 may be reportable by them under SOX § 307 if it amounts to “evidence of a material violation” as defined in the SOX § 307 Rules.

F. Foreign Private Issuers

There is no exemption or qualification in amended Rule 13b2-2 excluding foreign private issuers from its application.

452 See William R. Baker III & Joel H. Trotter, Corporate Internal Investigations after Sarbanes-Oxley, in 2 THE

PRACTITIONER’S GUIDE TO THE SARBANES-OXLEY ACT VII-4-1 (John J. Huber et al. eds., ABA 2004). 453 Cutler, supra note 25. 454 Timothy P. Harkness & Darren LaVerne, Private Lies May Lead to Prosecution—DOJ Views False

Statements to Private Attorney Investigators as a Form of Obstruction of Justice, NAT’L L.J., July 24, 2006, at S1. 455 SOX Title XI, entitled the “Corporate Fraud Accountability Act of 2002,” provides in § 1102 for up to twenty

years in prison for altering, destroying, or concealing anything with the intent to impair its use in any official proceeding, or any attempt to do so. SOX § 1102, amending 18 U.S.C.A. § 1512 (West Supp. 2007). SOX Section 1103 also authorizes the SEC to seek a temporary injunction to freeze extraordinary payments earmarked for designated persons or corporate staff under investigation for possible violations of federal securities laws. SOX § 1103, amending 15 U.S.C.A. § 78u-3 (West Supp. 2007).

456 United States v. Kumar, No. 04-cr-846, slip op. (E.D.N.Y. Feb. 21, 2006). 457 See United States v. Singleton, No. 4:04-cr-514-1 (S.D. Texas filed Nov. 17, 2004).


VIII. ENHANCED ATTORNEY RESPONSIBILITIES UNDER SOX

A. SOX § 307

SOX § 307 mandates that the SEC shall adopt rules of professional responsibility for attorneys representing public companies before the SEC, including “(1) requiring an attorney to report evidence of a material violation of securities law or breach of fiduciary duty to the chief legal officer or the equivalent (‘CLO’), if the issuer has a CLO, or to both the CLO and the CEO, of the company; and (2) if corporate executives do not respond appropriately, requiring the attorney to report to the board of directors or an appropriate committee thereof.”458 On January 23, 2003, the SEC complied with the SOX § 307 mandate by adopting the rules implementing provisions of SOX § 307 that “prescribe minimum standards of professional conduct for attorneys appearing and practicing before the [SEC] in any way in the representation of issuers.”459 These rules adopted under SOX § 307 (the “SOX § 307 Rules”) constitute a new Part 205 to 17 CFR, Standards of Professional Conduct for Attorneys Appearing and Practicing before the Commission, and became effective on August 5, 2003.

Generally, the SOX § 307 Rules require that, in the event that an attorney has “credible evidence based upon which it would be unreasonable, under the circumstances, for a prudent and competent attorney not to conclude that it is reasonably likely that a material violation of any U.S. law or fiduciary duty has occurred, is on going, or is about to occur,” the attorney has a duty to seek to remedy the problem by “reporting up the ladder” within the issuer.460 This standard, developed from the SEC’s attempt to make objective rather than subjective the test of when a lawyer must report a violation, has a lower threshold than a “more likely than not” standard. An attorney’s duty is not confined to matters as to which the attorney has formed a legal conclusion that there has been a material violation.461

B. Relationship to State Disciplinary Rules

The SOX § 307 Rules purport to set forth minimum standards of professional conduct for attorneys appearing and practicing before the SEC in the representation of an issuer. SOX § 307 standards are intended to supplement applicable standards of any jurisdiction where an

458 15 U.S.C. § 7245 (Supp. 2002). SOX attempts to protect investors from a repeat of the scandals that led to its

enactment by regulating “[t]he sentries of the marketplace: the auditors who sign off on companies’ financial data; the lawyers who advise companies on disclosure standards and other securities law requirements; the research analysts who warn investors away from unsound companies; and the boards of directors responsible for oversight of company management.” Cutler, supra note 25. See also Isselmann, Exchange Act Release No. 50,428, 83 SEC Docket 2413 (Sept. 23, 2004), available at http://www.sec.gov/litigation/admin/34-50428.htm (entering a consent cease and desist order against a general counsel who failed to advise the audit committee and auditors that he had received an opinion of local foreign counsel that the company could not eliminate benefits to its Asian employees where the benefits termination allowed the company to report a profit rather than a loss and which resulted in improper financial reporting in the Form 10-Q Report).

459 SEC, Final Rule: Implementation of Standards of Professional Conduct for Attorneys, Securities Act Release No. 8185, Exchange Act Release No. 47,276, Investment Company Act Release No. 25,919, 68 Fed. Reg. 6296, 6296 (Feb. 6, 2003), available at http://www.sec.gov/rules/final/33-8185.htm (the “SOX § 307 Release”).

460 Id. at 6301. 461 Id. at 6302.


attorney is admitted or practices, and are not intended to limit the ability of any jurisdiction to impose additional obligations on an attorney not inconsistent with the application of SOX § 307 Rules. Where the standards of a state or other U.S. jurisdiction where an attorney is admitted or practices conflict with SOX § 307 Rules, SOX § 307 Rules provide that they shall govern.462

C. Attorneys Covered

The SOX § 307 Rules apply to all attorneys, whether inside counsel or outside counsel and those in foreign jurisdictions, “appearing and practicing” before the SEC. The term “appearing and practicing” before the SEC is defined to include, without limitation: (1) transacting any business with the SEC, including communication in any form with the SEC; (2) representing an issuer in an SEC administrative proceeding or in connection with any SEC investigation, inquiry, information request or subpoena; (3) providing advice in respect of the U.S. securities laws regarding any document that the attorney has notice will be filed with or submitted to, or incorporated into any document that will be filed with or submitted to, the SEC, including the provision of such advice in the context of preparing, or participating in the preparation of, any such document;463 or (4) advising an issuer as to whether information or a statement, opinion, or other writing is required under the U.S. securities laws to be filed with or submitted to, or incorporated into any document that will be filed with or submitted to, the SEC; but does not include an attorney who (x) conducts these activities other than in the context of providing legal services to an issuer with whom the attorney has an attorney-client relationship;464 or (y) is a non-appearing foreign attorney.465

The SEC intends that the issue whether an attorney-client relationship exists for purposes of the SOX § 307 Rules will be a federal question and, in general, will turn on the expectations and understandings between the attorney and the issuer. Thus, whether the provision of legal services under particular circumstances would or would not establish an attorney-client relationship under the state laws or ethics codes of the state where the attorney practices or is

462 Id. at 6297. 463 The SOX § 307 Release notes that:

Mere preparation of a document that may be included as an exhibit to a filing with the [SEC] does not constitute “appearing and practicing before the [SEC]” . . . unless the attorney has notice that the document will be filed with or submitted to the [SEC] and he or she provides advice on [U.S.] securities law in preparing the document.

Id. at 6304 (emphasis added). Thus, preparing an employment contract for an executive officer would not be, but drafting a description of the contract for a proxy statement would be, “appearing and practicing” before the SEC.

464 The SOX § 307 Release notes that:

This portion of the definition [of “appearing and practicing” before the SEC] ha[s] the effect of excluding from coverage attorneys at public broker-dealers and other issuers who are licensed to practice law and who may transact business with the [SEC], but who are not in the legal department and do not provide legal services within the context of an attorney-client relationship.

Id. at 6298. 465 The SOX § 307 Rules incorporate a concept of “non-appearing foreign attorney” to address the situation of

attorneys who are admitted outside of the U.S., do not give advice as to U.S. securities laws and whose involvement with SEC matters is either peripheral or through U.S. counsel, and to relieve such attorneys of the responsibilities of the SOX § 307 Rules. Id.


admitted may be relevant to, but will not be controlling on, the issue under the SOX § 307 Rules.466

D. Who is the Client?

The SOX § 307 Rules affirmatively state that an attorney representing an issuer represents the issuer as an entity, rather than the officers or others with whom the attorney interacts in the course of that representation.467 State ethics rules likewise provide that the attorney owes his or her professional and ethical duties to the issuer as an organization.468 In the case of a large corporation with multiple subsidiaries, questions will arise as to whether the attorney represents the consolidated group or only a particular entity within, and the answers will vary depending on the unique facts of each situation.469 While the state ethics rules apply to both public and private companies, the SOX § 307 Rules apply only to attorneys in the representation of public companies.470

E. What Evidence Triggers Reporting Duty?

The SOX § 307 reporting duties are triggered when an attorney has “evidence of a material violation,” which is defined to mean credible evidence, based upon which it would be unreasonable, under the circumstances, for a prudent and competent attorney not to conclude that it is reasonably likely that a material violation has occurred, is ongoing, or is about to occur.471 “Material violation” in turn is defined to mean a material violation of an applicable

466 Id. at 6297–98. 467 Id. at 6305. 468 TEX. DISCIPLINARY R. PROF’L CONDUCT 1.12, reprinted in TEX. GOV’T CODE ANN., tit. 2, subtit. G app. A

(Vernon 1998) (TEX. STATE BAR R. art. X, § 9) (providing that “[a] lawyer employed or retained by an organization represents the entity” rather than the individuals to whom the lawyer reports in the ordinary course of working relationships). See also MODEL RULES OF PROF’L CONDUCT R. 1.13(a) (2002) (“a lawyer employed or retained by an organization represents the organization acting through its duly authorized constituents”).

469 Attorneys’ engagement letters sometimes are very specific as to the representation being solely of a specified entity and not any parent or subsidiary entities or related persons; sometimes the client will want the attorneys to agree that the client is all of the members of the consolidated group.

470 Commodity and Securities Exchanges, 17 C.F.R. § 205.3 (2008). 471 17 C.F.R. § 205.2(e) (2008). The SOX § 307 Release comments that the definition of “evidence of a material

violation” is an objective standard, instead of “a subjective standard [which would] requir[e] ‘actual belief’ that a material violation has occurred, is ongoing, or is about to occur before the attorney would be obligated to make an initial report within the client issuer.” SOX § 307 Release, supra note 459, at 6301. In explaining how the definition’s objective standard should be interpreted, the SOX § 307 Release states:

Evidence of a material violation must first be credible evidence. An attorney is obligated to report when, based upon that credible evidence, “it would be unreasonable, under the circumstances, for a prudent and competent attorney not to conclude that it is reasonably likely that a material violation has occurred, is ongoing, or is about to occur.” This formulation, while intended to adopt an objective standard, also recognizes that there is a range of conduct in which an attorney may engage without being unreasonable. The “circumstances” are the circumstances at the time the attorney decides whether he or she is obligated to report the information. These circumstances may include, among others, the attorney’s professional skills, background and experience, the time constraints under which the attorney is acting, the attorney’s previous experience and familiarity with the client, and the availability of other lawyers with whom the lawyer may consult. Under the revised definition, an attorney is not required (or expected) to report “gossip, hearsay, [or] innuendo.” Nor is


United States federal or state securities law, a material “breach of fiduciary duty” arising under United States federal or state law, or a similar material violation of any United States federal or state law. The SOX § 307 Release comments that the SOX § 307 Rules do not contain a separate definition of “material” because “that term has a well-established meaning under the federal securities laws and the [SEC] intends for that same meaning to apply” under the SOX § 307 Rules.472 The SOX § 307 Release, however, does comment “that material violations must arise under United States law (federal or state) and do not include violations of foreign laws.” “Breach of fiduciary duty” under the SOX § 307 Rules “refers to any breach of fiduciary or similar duty to the issuer recognized under an applicable federal or state statute or at common law, including but not limited to misfeasance, nonfeasance, abdication of duty, abuse of trust, and approval of unlawful transactions.”473

the rule’s reporting obligation triggered by “a combination of circumstances from which the attorney, in retrospect, should have drawn an inference,” as one commenter feared.

On the other hand, the rule’s definition of “evidence of a material violation” makes clear that the initial duty to report up-the-ladder is not triggered only when the attorney “knows” that a material violation has occurred or when the attorney “conclude[s] there has been a violation, and no reasonable fact finder could conclude otherwise.” That threshold for initial reporting within the issuer is too high. Under the Commission’s rule, evidence of a material violation must be reported in all circumstances in which it would be unreasonable for a prudent and competent attorney not to conclude that it is “reasonably likely” that a material violation has occurred, is ongoing, or is about to occur. To be “reasonably likely” a material violation must be more than a mere possibility, but it need not be “more likely than not.” If a material violation is reasonably likely, an attorney must report evidence of this violation. The term “reasonably likely” qualifies each of the three instances when a report must be made. Thus, a report is required when it is reasonably likely a violation has occurred, when it is reasonably likely a violation is ongoing or when reasonably likely a violation is about to occur.

Id. at 6302. 472 SOX § 307 Release, supra note 459, at 6303; 17 C.F.R. § 205.2(i) (2008). The SOX § 307 Release cites

Basic, Inc. v. Levinson, 485 U.S. 224, 231–36 (1988) and TSC Indus. v. Northway, Inc., 426 U.S. 438 (1976) for the generally accepted definition of “material.” Materiality is defined in those cases as follows:

An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote. . . . It does not require proof of a substantial likelihood that disclosure of the omitted fact would have caused the reasonable investor to change his vote. What the standard does contemplate is a showing of a substantial likelihood that, under all the circumstances, the omitted fact would have assumed actual significance in the deliberations of the reasonable shareholder. Put another way, there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.

TSC Indus., 426 U.S. at 449 (expressly adopted in Basic, Inc. at 231–32). See 15 U.S.C. § 7245 (Supp. 2007). 473 SOX § 307 Release, supra note 459, at 6301; 17 C.F.R. § 205.2(d) (2008). In Texas and Delaware:

[b]oth . . . TBCA [art. 2.31] and DGCL [§ 141(a)] provide that the business and affairs of a corporation are to be managed under the direction of its board of directors. While the [Texas and Delaware corporation statutes] provide statutory guidance as to matters such as the issuance of securities, the payment of dividends, the conduct of meetings of directors and shareholders, and the ability of directors to rely on specified persons and information, the nature of a director’s “fiduciary” duty to the corporation and the shareholders has been largely defined by the courts through damage and injunctive actions.

Byron F. Egan & Curtis W. Huff, Choice of State of Incorporation—Texas versus Delaware: Is It Now Time To Rethink Traditional Notions?, 54 SMU L. REV. 249, 259 (2001). In Texas, “[t]hree broad duties stem from the fiduciary status of corporate directors; namely the duties of obedience, loyalty, and due care.” Gearhart Indus., Inc. v. Smith Int’l, Inc., 741 F.2d 707, 719 (5th Cir. 1984). Gearhart describes those duties as follows:

[(i) t]he duty of obedience requires a director to avoid committing ultra vires acts, i.e., acts beyond the


F. Duty to Report Evidence of a Material Violation

If an attorney, appearing and practicing before the SEC “in the representation of an issuer,”474 becomes aware of evidence of a material violation by the issuer or by any officer, director, employee or agent of the issuer, the SOX § 307 Rules require the attorney to “report”475 the evidence to the issuer’s CLO (if the issuer has a CLO) or to both the issuer’s CLO and its CEO forthwith. By communicating such information to the issuer’s officers or directors, an attorney does not reveal client confidences or secrets or privileged or otherwise protected information related to the attorney’s representation of an issuer.476

The CLO is then obligated to cause such inquiry477 into the evidence of a material violation as he or she “reasonably believes”478 is appropriate to determine whether the material violation described in the report has occurred, is ongoing, or is about to occur. If the CLO determines no material violation has occurred, is ongoing, or is about to occur, he or she shall notify the reporting attorney and advise the reporting attorney of the basis for such determination. Unless the CLO reasonably believes that no material violation has occurred, is ongoing, or is about to occur, he or she shall take all reasonable steps to cause the issuer to

scope of the [authority] of the corporation as defined by its [articles of incorporation] or the laws of the state of incorporation . . .[, (ii) t]he duty of loyalty dictates that a director must act in good faith and must not allow his personal interests to prevail over the interests of the corporation . . .[, and (iii)] the duty of due care requires . . . [that] a director must handle his corporate duties with such care as an ordinarily prudent man would use under similar circumstances.

Id. at 719–20. In Delaware, the fiduciary duties include those of loyalty, care, candor and oversight. Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985); In re Caremark Int’l, Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996); See In re Abbott Lab. Derivative S’holders Litig., 325 F.3d 795 (7th Cir. 2003). Note that:

[b]oth Texas and Delaware have adopted a judicial rule of review [of] business decisions, known as the “business judgment rule,” that is intended to protect disinterested directors from liability for decisions made by them when exercising their business judgment, but [there] are substantial differences [in] the Delaware and Texas judicial approaches to the business judgment rule.

Egan & Huff, at 287–88. The extent to which traditional business judgment rule analyses will be applicable in respect of SOX requirements is unclear.

474 The SOX § 307 Rules define “in the representation of an issuer” to “mean[] providing legal services as an attorney for an issuer, regardless of whether the attorney is employed or retained by the issuer. 17 C.F.R. § 205.2(g) (2008).

475 The SOX §307 Rules define “report” to “mean[] to make known to directly, either in person, by telephone, by e-mail, electronically, or in writing.” 17 C.F.R. § 205.2(n) (2008).

476 17 C.F.R. § 205.3(b)(1) (2008). 477 An attorney conducting an inquiry into reported evidence of a material violation would be deemed appearing

and practicing before the SEC in the representation of the issuer. 17 C.F.R. § 205.3(b)(5) (2008). The attorney reporting the evidence to the CLO could be a person commissioned by the CLO to conduct the inquiry into the evidence. 17 C.F.R. § 205.3 (2008). The inquiry is important not only for what it finds about the possible violation which initiated the inquiry, but also for any additional possible violations which it may uncover. See SOX § 307 Release, supra note 459.

478 The SOX §307 Rules provide that “reasonably believes” to “mean[] that an attorney believes the matter in question and that the circumstances are such that the belief is not unreasonable,” and that “reasonable” or “reasonably” “denote[], with respect to the actions of an attorney, conduct that would not be unreasonable for a prudent and competent attorney.” 17 C.F.R. § 205.2(m) (2008).


adopt an “appropriate response,”479 and shall advise the reporting attorney thereof. In lieu of causing such an inquiry a CLO may refer a report of evidence of a material violation to a qualified legal compliance committee (“QLCC”) if the issuer has duly established a QLCC prior to the report of evidence of a material violation.480

Unless an attorney who has made the report reasonably believes that the CLO or CEO has provided an appropriate response within a reasonable time, the attorney shall report the evidence of a material violation to: (i) the issuer’s audit committee, (ii) another committee consisting solely of independent directors, or (iii) the board of directors.481

If an attorney reasonably believes that it would be futile to report evidence of a material violation to the issuer’s CLO and CEO, the attorney may bypass them and report the evidence to the board or an appropriate committee.482

An attorney retained or directed by an issuer to investigate evidence of a reported material violation shall be deemed to be appearing and practicing before the SEC. Directing or retaining an attorney to investigate reported evidence of a material violation does not relieve an

479 “Appropriate response” is defined by the SOX § 307 Rules as:

a response to an attorney regarding reported evidence of a material violation as a result of which the attorney reasonably believes [that]: (1) . . . no material violation . . . has occurred, is ongoing, or is about to occur; (2) . . . the issuer has, as necessary, adopted appropriate remedial measures, including appropriate steps or sanctions to stop any material violations that are ongoing, to prevent any material violation that has yet to occur, and to remedy or otherwise appropriately address any material violation that has already occurred and to minimize the likelihood of its recurrence; or (3) . . . the issuer, with the consent of the issuer’s board of directors, a[n appropriate] committee thereof . . . or a [QLCC], has retained or directed an attorney to review the reported evidence of a material violation and either ([x]) [h]as substantially implemented any remedial recommendations made by such attorney after a reasonable investigation and evaluation of the reported evidence . . . or ([y]) [h]as been advised that such attorney may, consistent with his or her professional obligations, assert a colorable defense on behalf of the issuer (or the issuer’s officer, director, employee, or agent, as the case may be) in any investigation or judicial or administrative proceeding relating to the reported evidence of a material violation.

17 C.F.R. § 205.2(b) (2008). 480 17 C.F.R. § 205.3(b)(2) (2008). 481 17 C.F.R. § 205.3(b)(3) (2008). See Patrick McGeehan, Lawyers Take Suspicions On TV Azteca To Its Board,

N.Y. TIMES, December 24, 2003, at C1:

In one of the first applications of a new provision of the Sarbanes-Oxley Act, outside lawyers for Mexico’s second-largest broadcaster have told its board—and, possibly, federal regulators—that they think that the company violated United States securities laws.

The company, TV Azteca, has had a long-running dispute with lawyers in New York about the need for greater disclosure about transactions that could have yielded a profit of more than $100 million to the company’s billionaire chairman and controlling shareholder, Ricardo B. Salinas Pliego. When company executives refused to make the disclosures that the lawyers demanded, the lawyers cited the new provision of the act, which requires them to notify the company’s board and permits them to contact regulators as well.

. . . [I]n a Dec. 12 letter to the boards of TV Azteca and its parent company, Azteca Holdings, [outside New York counsel citing SOX §307] told the boards that [the firm] was withdrawing as counsel to the company on a pending bond offering and that it might notify the Securities and Exchange Commission of its withdrawal and the reasons for it.

482 17 C.F.R. § 205.2(b)(4) (2008).


officer or director of the issuer to whom such evidence has been reported from a duty to respond to the reporting attorney.483

An attorney shall not have any obligation to report evidence of a material violation if (i) the attorney was retained or directed by the issuer’s CLO to investigate such evidence of a material violation and reports the results of such investigation to the CLO and to the board or an appropriate committee or each of the attorney and the CLO reasonably believes that no material violation has occurred, is ongoing, or is about to occur, or (ii) the attorney was retained or directed by the CLO to assert, consistent with his or her professional obligations, a colorable defense on behalf of the issuer (or the issuer’s officer, director, employee, or agent, as the case may be) in any investigation or judicial or administrative proceeding relating to such evidence of a material violation, and the CLO provides reasonable and timely reports on the progress and outcome of such proceeding to the issuer’s board or appropriate committee.484

An attorney shall not have any obligation to report evidence of a material violation if the attorney was retained or directed by a QLCC to either investigate such evidence of a material violation or to assert, consistent with his or her professional obligations, a colorable defense on behalf of the issuer (or the issuer’s officer, director, employee, or agent, as the case may be) in any investigation or judicial or administrative proceeding relating to such evidence of a material violation.485

An attorney who receives what he or she reasonably believes is an appropriate and timely response to a report he or she has made need do nothing more under the SOX § 307 Rules with respect to his or her report.486

An attorney who does not reasonably believe that the issuer has made an appropriate response within a reasonable time to the report or reports made shall explain the reason behind his or her belief to the CLO, the CEO, and the directors to whom the attorney reported the evidence of a material violation.487

An attorney formerly employed or retained by an issuer who has reported evidence of a material violation under the SOX § 307 Rules and reasonably believes that he or she has been discharged for so doing may notify the issuer’s board of directors or any committee thereof that he or she believes that he or she has been discharged for reporting evidence of a material violation.488 Discharging an attorney/employee for reporting under the SOX § 307 Rules would violate the whistleblower protections afforded by SOX § 806.

The SOX § 307 Rules are specific as to how reports thereunder must be made and how the recipient of the report must investigate and respond to the report. The SOX § 307 Rules do not restrict informal communication between the issuer representatives and the attorney to resolve

483 17 C.F.R. § 205.2(b)(5) (2008). 484 17 C.F.R. § 205.2(b)(6) (2008). 485 17 C.F.R. § 205.2(b)(7) (2008). 486 17 C.F.R. § 205.2(b)(8) (2008). 487 17 C.F.R. § 205.2(b)(9) (2008). 488 17 C.F.R. § 205.2(b)(9) (2008).


the issue, but in the event that the SOX § 307 Rules are triggered, the SOX § 307 Rules should be promptly and literally complied with, even if it duplicates prior communications informally made to responsible issuer representatives.

G. Alternative Reporting Procedures For An Issuer That Has Established A QLCC

If an attorney, appearing and practicing before the SEC in the representation of an issuer, becomes aware of evidence of a material violation by the issuer or by any officer, director, employee, or agent of the issuer, the attorney may, as an alternative to the preceding reporting requirements, report such evidence directly to a QLCC, if the issuer has formed such a committee. An attorney who reports evidence of a material violation to a QLCC has satisfied his or her obligation to report such evidence and is not required to assess the issuer’s response to the reported evidence of a material violation.489

A CLO may refer a report of evidence of a material violation to a QLCC in lieu of causing an inquiry to be conducted, and shall inform the reporting attorney that the report has been referred to a QLCC. Thereafter, the QLCC shall be responsible for responding to the evidence of a material violation reported to it.490

H. Issuer Confidences

The SOX § 307 Rules provide that “[a]ny report under this section . . . or any response thereto (or [any] contemporaneous record [of the report or the response]) may be used by an attorney in connection with any investigation, proceeding, or litigation in which the attorney’s compliance with [the SOX § 307 Rules] is in issue.” In the SOX § 307 Release, the SEC states that it is making clear that an attorney may use any records the attorney may have made in the course of fulfilling his or her reporting obligations under this part to defend himself or herself against charges of misconduct, and that the SOX § 307 Rules are effectively equivalent to the ABA’s present Model Rule 1.6(b)(3) and corresponding ‘self-defense’ exceptions to client-confidentiality rules in every state.491

489 17 C.F.R. § 205.3(c)(1) (2008). 490 17 C.F.R. § 205.3(c)(2) (2008). 491 SOX § 307 Release, supra note 459, at 6310. The Texas Disciplinary Rules of Professional Conduct provide

as follows:

RULE 1.05. CONFIDENTIALITY OF INFORMATION

(b) Except as permitted by paragraphs (c) and (d), or as required by paragraphs (e) and (f), a lawyer shall not knowingly:

(1) Reveal confidential information of a client or a former client. . . .

(c) A lawyer may reveal confidential information:

(5) To the extent reasonably necessary to enforce a claim or establish a defense on behalf of the lawyer in a controversy between the lawyer and the client.

(6) To establish a defense to a criminal charge, civil claim or disciplinary complaint against the lawyer or the lawyers associates based upon conduct involving the client or the representation of


The SOX § 307 Rules further provide that an attorney appearing and practicing before the SEC in the representation of an issuer may reveal to the SEC, without the issuer’s consent, confidential information related to the representation to the extent the attorney reasonably believes necessary: (i) to prevent the issuer from committing a material violation that is likely to cause substantial injury to the financial interest or property of the issuer or investors; (ii) to prevent the issuer from committing or suborning perjury or committing any act that is likely to perpetrate a fraud upon the SEC; or (iii) to rectify the consequences of a material violation by the issuer that caused, or may cause, substantial injury to the financial interest or property of the issuer or investors in the furtherance of which the attorney’s services were used. The SOX § 307 Release comments that in permitting, but not requiring, an attorney to disclose, under specified circumstances, confidential information related to his appearing and practicing before the SEC in the representation of an issuer, the SOX § 307 Rules correspond to the ABA’s Model Rule 1.6 as proposed by the ABA’s Kutak Commission in 1981-1982 and by the ABA’s Commission of Evaluation of the Rules of Professional Conduct (“Ethics 2000 Commission”) in 2000, and as adopted in the vast majority of states.492

I. Responsibilities of Supervisory Attorneys

An attorney supervising or directing another attorney who is appearing and practicing before the SEC in the representation of an issuer is a “supervisory attorney” and is required to make reasonable efforts to ensure that a subordinate attorney that he or she supervises or directs conforms to the SOX § 307 Rules.493 Supervising an attorney in the representation of an issuer in non-SEC related matters, or overall management of a law firm, would not result in an attorney being considered a “supervisory attorney” for SOX § 307 purposes.494

A supervisory attorney is responsible for complying with the reporting requirements when a subordinate attorney has reported to the supervisory attorney evidence of a material violation and may report evidence of a material violation from a subordinate attorney to the issuer’s QLCC.495

the client.

(7) When the lawyer has reason to believe it is necessary to do so in order to prevent the client from committing a criminal or fraudulent act.

(8) To the extent revelation reasonably appears necessary to rectify the consequences of a client's criminal or fraudulent act in the commission of which the lawyer's services had been used.

(e) When a lawyer has confidential information clearly establishing that a client is likely to commit a criminal or fraudulent act that is likely to result in death or substantial bodily harm to a person, the lawyer shall reveal confidential information to the extent revelation reasonably appears necessary to prevent the client from committing the criminal or fraudulent act.

TEX. DISCIPLINARY R. PROF’L CONDUCT 1.05, reprinted in TEX. GOV’T CODE ANN. tit. 2, subtit. G App. A (Vernon 1998).

492 SOX § 307 Release, supra note 459, at 6310. 493 17 C.F.R. § 205.4(a–b) (2008) (emphasis added). 494 SOX § 307 Release, supra note 459. 495 17 C.F.R. § 205.4(c–d) (2008).


J. Responsibilities of a Subordinate Attorney

An attorney who appears and practices before the SEC in the representation of an issuer on a matter under the supervision or direction of another attorney (other than under the direct supervision or direction of the issuer’s CLO) is a “subordinate attorney” and is obligated to comply with the SOX § 307 Rules notwithstanding that the subordinate attorney acted at the direction of or under the supervision of another person.496

A subordinate attorney complies with the SOX § 307 Rules if the subordinate attorney reports to his or her supervising attorney evidence of a material violation of which the subordinate attorney has become aware in appearing and practicing before the SEC, but may “report up the ladder” if the subordinate attorney reasonably believes that the supervisory attorney to whom he or she has reported evidence of a material violation has failed to comply with the SOX § 307 Rules.497

K. Sanctions and Discipline

A violation of the SOX § 307 Rules by any attorney appearing and practicing before the SEC in the representation of an issuer subjects such attorney to the civil penalties and remedies for a violation of the federal securities laws available to the SEC, regardless of whether the attorney may also be subject to discipline for the same conduct in a jurisdiction where the attorney is admitted or practices.498

An attorney who complies in good faith with the provisions of the SOX § 307 Rules is not subject to discipline or otherwise liable under inconsistent standards imposed by any state or other United States jurisdiction where the attorney is admitted or practices.499

Issues of compliance with the SOX § 307 Rules will likely arise when a corporate debacle emerges and the SEC staff investigates to find out who knew what and when, and asks where the lawyers were. In that context, the SEC staff will look at whether there was compliance with the SOX § 307 Rules. Under such circumstances, lawyers would be more comfortable if they could point to strict compliance with the SOX § 307 Rules rather than trusting prosecutorial discretion to conclude that substantial compliance was good enough.

L. No SOX § 307 Private Right of Action

The SOX § 307 Rules provide that “nothing [therein] is intended to, or does, create a private right of action against any attorney, law firm, or issuer based upon compliance or noncompliance with its provisions. . . . Authority to enforce compliance with [the SOX § 307 Rules] is vested exclusively in the [SEC].”500

496 17 C.F.R. § 205.5(a–b) (2008) (emphasis added). 497 17 C.F.R. § 205.5(c–d) (2008). 498 17 C.F.R. § 205.6(a–b) (2008). 499 17 C.F.R. § 205.6(c) (2008). 500 17 C.F.R. § 205.7 (2008).


M. Enron Civil Liability Fallout

Compliance with the requirements of the SOX § 307 Rules does not assure attorneys that they will not be subject to private claims based on other securities laws.501 In Judge Melinda Harmon’s lengthy opinion dated December 19, 2002 on the motions to dismiss filed by Vinson & Elkins L.L.P. (“V&E”), Kirkland & Ellis (“K&E”), Arthur Andersen LLP, and nine banks in the Newby v. Enron case, she granted the motions to dismiss of K&E and Deutsche Bank, but denied in whole or in part the motions of V&E, Arthur Andersen, J.P. Morgan Chase, Citigroup, Credit Suisse, CIBC, Merrill Lynch, Barclays, Lehman Brothers, and Bank America. In exploring the circumstances under which law firms, accounting firms, and investment banks/integrated financial services institutions (lumped together by the court as “secondary actors in securities markets”) can be liable for the acts of companies they serve under SEC Rule 10b-5 and the Texas Securities Act, the court noted that it was influenced by revelations of corporate corruption in other courts, Congress, investigations by the SEC and New York Attorney General Eliot Spitzer, and the media.502

While paying homage to the 1994 holding of the Supreme Court in Central Bank of Denver503 that a private plaintiff may not bring an aiding and abetting claim under Rule 10b-5, the court found that the Supreme Court left open for it to determine when the conduct of a secondary actor makes it a primary violator subject to liability under Rule 10b-5. Rejecting the “bright line” test that a defendant must actually make a false or misleading statement to be liable, the Court adopted the SEC’s amicus position that a defendant can be liable if it “creates” a misleading document even though the defendant is not identified with it to the outside world, with “reliance” being established under the “fraud on the market” theory.504 “Scienter” remains a crucial element, with the plaintiff having to show intent to deceive or extreme recklessness to sustain a Rule 10b-5 claim.

The court gave a broad reading to the liability provisions of the Texas Securities Act,505 commenting that “liability may be imposed against a defendant [who] constituted any link in the chain of the selling process” and that proof of reliance or scienter are not required. The court found that the Texas Securities Act “applies if any act in the selling process of securities .

501 See Memorandum and Order Re Secondary Actors’ Motion to Dismiss filed December 20, 2002, In re Enron

Corp. Securities, Derivative and ERISA Litigation, 235 F. Supp. 2d 549 (S.D. Tex. 2002) (the opinion is 159 pages long in F. Supp. 2d). This case is also known as Newby v. Enron or the Newby case.

502 Id. 503 Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994) (holding that SEC Rule 10b-5

prohibits only the making of a material misstatement or omission (or the commission of a manipulative act) and does not prohibit the giving of aid to another who then commits a primary Rule 10b-5 violation).

504 The Court in Newby wrote:

Any person or entity, including a lawyer, accountant, or bank, who employs a manipulative device or makes a material misstatement (or omission) on which a purchaser or seller of securities relies may be liable as a primary violator under 10b-5, assuming all of the requirements for primary liability . . . are met.

235 F. Supp. 2d 549, 582 (S.D. Tex. 2002). 505 TEX. REV. CIV. STAT. ANN. art. 581, § 33 (Vernon Supp. 2006).


. . occurs in Texas.”506

With respect to attorney liabilities, the court acknowledged that Texas law requires privity for malpractice liability, but found that claims for fraudulent or negligent misrepresentation can be made by those who the attorney had reason to know would rely on the information and who justifiably relied on it.507 The court concluded that:

professionals, including lawyers and accountants, when they take the affirmative step of speaking out, whether individually or as essentially an author or co-author in a statement or report, whether identified or not, about their client’s financial condition, do have a duty to third parties not in privity not to knowingly or with severe recklessness issue materially misleading statements on which they intend or have reason to expect that those third parties will rely.508

In denying V&E’s motion to dismiss, the court recited V&E’s involvement in structuring the partnerships and special purpose entities (“SPEs”) that contributed to Enron’s demise and in working on its SEC filings and other public disclosures, and found that V&E “was necessarily privy to its client’s confidences and intimately involved in and familiar with the creation and structure of its numerous businesses, and thus, as a law firm highly sophisticated in commercial matters, had to know of the alleged ongoing illicit and fraudulent conduct.”509 The court wrote that V&E “was not merely a drafter, but essentially a co-author of the documents it created for public consumption.”510 The court commented:

[r]evelant to Vinson & Elkins’ undertaking of the investigation of Enron in the fall of 2001, [Texas Rule of Professional Conduct] 1.06(a)(2) bars a lawyer from representing a client where that representation “reasonably appears to be or becomes limited by the lawyer’s or law firm’s own interests . . . ,” [and under such circumstances] a client’s consent is not effective.511

However, the court dismissed the lawsuit as to K&E, calling the charges against K&E “conclusory and general.”512 The court said any documents K&E drafted were for private transactions, “and were not included in or drafted for any public disclosure or shareholder solicitation” and noted that K&E was not Enron’s counsel for its securities or SEC filings.513

506 Brown v. Cole, 155 Tex. 624, 291 S.W.2d 704, 708 (Tex. 1956); Rio Grande Oil Co. v. State, 539 S.W.2d

917, 922 (Tex. Civ. App.—Houston [1st Dist.] 1976, writ ref’d n.r.e.); Texas Capital Securities, Inc. v. Sandefer, 58 S.W.3d 760, 775 (Tex. App.—Houston [1st Dist.] 2001, pet. denied).

507 In re Enron Corp. Sec. Litig., 235 F. Supp. 2d at 549. 508 Id. at 610. 509 Id. at 704. 510 Id. at 705. 511 Id. 512 Id. at 705–06. 513 Id. at 706.


N. Attorney-Client/Work Product Privilege

The SOX § 307 Rules do not contain any provision to the effect that information reported by an attorney to the SEC does not constitute a waiver of any attorney-client or other privilege. The SOX § 307 Release states that the SEC finds that allowing issuers to produce internal reports to the SEC, including those prepared in response to reports as a result of the SOX § 307 Rules, without waiving an otherwise applicable attorney-client and other privilege, enhances the SEC’s investigatory and enforcement capabilities and, thus, is in the public interest.

The SOX § 307 Release further states that the SEC will continue to follow its policy of entering into confidentiality agreements where it determines that its receipt of information pursuant to those agreements will ultimately further the public interest, and will vigorously argue in defense of those confidentiality agreements where litigants argue that the disclosure of information pursuant to such agreements waives any privilege or protection.514

O. Differences From Proposed Rules

On November 21, 2002, the SEC issued 1933 Act Release No. 33-8150 that proposed rules under SOX § 307.515 After comment, the final SOX § 307 Rules were issued on January 29, 2003 and differ in a number of respects from the initially proposed rules.

The final SOX § 307 Rules continue to emphasize, as did the proposed rules, that a lawyer for the corporation owes allegiance to the corporation and not to the individual who was responsible for retaining the lawyer or the lawyer’s firm, but differ from the proposed rules in at least three important respects: First, in a reluctant retreat from the proposed “noisy withdrawal” rule, which many felt would have involved a breach of the attorney-client privilege, securities lawyers will not be required, if company executives and the board do not respond appropriately to a lawyer’s warning or expressed concern that a material securities violation has occurred or will occur, to resign representation, report to the SEC that their resignation is for “professional reasons,” and disaffirm any “tainted” documents filed with or submitted to the SEC.

Instead, the SEC extended for 60 days the comment period on the “noisy withdrawal” proposal, while proposing an alternative that still would require a lawyer to withdraw, but that would place instead upon the company the burden to report the lawyer’s withdrawal.516 Under the proposed alternative, the company would publicly disclose on a Form 8-K within two

514 SOX § 307 Release, supra note 459, at 6311–13. In Saito v. McKesson HBOC, Inc., the Delaware Chancery Court, while acknowledging inconsistent holdings from other jurisdictions, held that the attorney work product privilege had not been waived as to private litigants in respect of documents furnished to the SEC pursuant to a confidentiality agreement during an SEC investigation, but had been waived as to documents furnished to the SEC before a confidentiality agreement had been executed as there was no common interest with the SEC which was more foe than friend. No. 18553, 2002 WL 31657622 (Del. Ch. Nov. 13, 2002).

515 Implementation of Standards of Professional Conduct for Attorneys, Securities Act Release No. 8150, Exchange Act Release No. 47,282, Investment Company Act Release No. 25,920, 67 Fed. Reg. 71,670 (Nov. 21, 2002), available at http://www.sec.gov/rules/proposed/33-8150.htm.

516 See Securities Act Release No. 8186, Exchange Act Release No. 48,282, Investment Company Act Release No. 25,920, 79 SEC Docket 1392 (Jan. 29, 2003), available at http://www.sec.gov/rules/proposed/33-8186.htm.


business days after the lawyer’s withdrawal for professional considerations, or of having received a notice from its lawyer that the issuer did not appropriately respond to the lawyer’s report of a material violation, either or both of such events.517 If the company does not make the required disclosure, the lawyer would then be permitted (but not required) to inform the SEC that he or she had withdrawn. Inside counsel would be required only to cease participating in the matter involving the violation and notify the company in writing that he or she believed the company had not appropriately responded to the lawyer’s report of a material violation.

Second, the SEC changed the text of the rule specifying when lawyers must report “up the ladder.” Under proposed rules, a lawyer had to report up the ladder if he had “evidence of a material violation of securities law or breach of fiduciary duty or similar violation” by a client.518 Under the final rules adopted, a lawyer must report “credible evidence based upon which it would be unreasonable, under the circumstances, for a prudent and competent attorney not to conclude that it is reasonably likely that a material violation has occurred, is ongoing, or is about to occur.”519 While this standard developed from the SEC’s attempt to make objective rather than subjective the test of when a lawyer must report a violation, its tortured manner of expression, in terms of a double negative (“unreasonable . . . not to conclude that it is reasonably likely . . .”), may simply increase the SEC’s burden of proving a lawyer has failed to comply. In response to questions at the open meeting, the SEC staff suggested that this standard has a lower threshold than a “more likely than not” standard.520

Third, the final SOX § 307 Rules clarify that they cover lawyers providing legal services who have an attorney-client relationship, and then only if the lawyer has notice that documents they are preparing or assisting in preparing will be filed with or submitted to the SEC.521

Other highlights of the final SOX § 307 Rules include: (a) removal of the requirement that issuers and their lawyers document reports of violations and the related responses; (b) clarification of coordination with state-mandated reporting obligations: namely, that the final SOX § 307 Rules control if they conflict with less rigorous reporting requirements under state law, but that more rigorous state-imposed up-the-ladder reporting obligations will control, as long as they are not inconsistent with these rules; and (c) affirmation that the final SOX § 307 Rules are enforceable exclusively by the SEC and do not create any private right of action.522

Finally, the proposed SOX § 307 rules provided that an issuer does not waive any applicable privileges by sharing confidential information regarding misconduct by the issuer’s employees or officers with the SEC pursuant to a confidentiality agreement, but this was replaced in the final rule release with commentary that such is the SEC’s view of good public policy.523

517 Id. 518 Securities Act Release No. 8150, supra note 515, at 71,673 (emphasis added). 519 SOX § 307 Release, supra note 459, at 6296 (emphasis added). 520 Id. at 6302. 521 Id. at 6298. 522 Id. at 6306. 523 Id. at 6303, 6313; See also Securities Act Release No. 8186, supra note 516.


IX. ATTORNEY LETTERS TO AUDITORS

A. SFAS 5

In March 1975, the Financial Standards Board (“FASB”) issued its Statement of Financial Accounting Standards No. 5 (“SFAS 5”)524 entitled “Accounting for Contingencies” which sets forth the standards for issuers to accrue for or disclose loss contingencies. Under SFAS 5 if both a loss is “probable” and the amount can be reasonably estimated, the contingency has to be accrued in the financial statements of the company. On the other hand, if it is reasonably possible (but not probable) that a loss has occurred or will occur, then there has to be disclosure in the footnotes to the financial statements and an estimate of that loss or range of losses has to be provided, if one can be provided. Under SFAS 5 “probable” means “the future event or events are likely to occur,” “reasonably possible” means that “the chance of the future event or events occurring is more than remote and less than likely,” and “remote” means that “the chance of the future event or events occurring is slight.”525

B. SAS 12

In January 1976, the American Institute of Certified Public Accountants (the “AICPA”) issued its Statement on Auditing Standards No. 12 (“SAS 12”), entitled Inquiry of a Client’s Lawyer concerning Litigation, Claims, and Assessments,526 which purports to provide “guidance on the procedures an independent auditor should consider for identifying litigation, claims, and assessments and for satisfying himself as to the financial accounting and reporting for such matters when he is performing an examination in accordance with generally accepted auditing standards.”527 SAS 12 sets forth the auditing process to be followed by auditors in gathering information to confirm that the client has made the appropriate determinations required by SFAS 5, and remains operative today even after the enactment of SOX and the establishment of the PCAOB.528 SAS 12 is really the auditing standard implementing the process under SFAS 5 and it provides guidelines for the types of inquiries that the client will make of the lawyer.

Pursuant to SAS 12, the auditor must obtain evidence regarding the following factors:

• The existence of a condition, situation, or set of circumstances indicating an

524 ACCOUNTING FOR CONTINGENCIES, Fin. Accounting Standards No. 5 (Fin. Accounting Standard Bd. 1975)

[hereinafter SFAS 5], available at http://www.sec.gov/interps/account/sabcodet5.htm. 525 Id. In the ABA Statement of Policy the respective definitions are slightly different. ABA AUDITOR’S LETTER

HANDBOOK (2003) [hereinafter ABA Handbook]. 526 INQUIRY OF A CLIENT’S LAWYER CONCERNING LITIGATION, CLAIMS, AND ASSESSMENTS, Statement on

Auditing Standards No. 12 (American Inst. of Certified Pub. Accounts 1976), available at http://www.aicpa.org/download/members/div/auditstd/AU-00337.PDF, reprinted in ABA Handbook, supra note 525 [hereinafter SAS 12]. SAS 12 has been adopted as an interim audit standard by the PCAOB.

527 SAS 12, at § 1. 528 The PCAOB has adopted the generally accepted auditing standards that existed on April 16, 2003 as the

interim PCAOB standards. PCAOB Rulemaking: Public Company Accounting Oversight Board, Exchange Act Release No. 49,707, 82 SEC Docket 3079 (May 14, 2004), available at http://www.sec.gov/rules/pcaob/34-49707.htm.


uncertainty as to the possible loss to an entity arising from litigation, claims, and assessments;

• The period in which the underlying cause for legal action occurred;

• The degree of probability of an unfavorable outcome; and

• The amount or range of potential loss.529

The auditor is instructed to seek such evidence from management.530 However, because auditors are not equipped to make legal judgments regarding such matters, SAS 12 instructs the auditor to “request the client’s management to send a letter of inquiry to those lawyers with whom they consulted concerning litigation, claims, and assessments”531 (an “Inquiry Letter”). The Inquiry Letter that lawyers receive is from the client, not from the auditors, although it probably was drafted by the auditors.532 The Inquiry Letter might also cover the additional category of contractually assumed obligations, but such inquiries are rarely made.

The matters to be addressed in an Inquiry Letter to counsel include the following:

• Identification of the company, including subsidiaries, and the date of the examination;

• A list prepared by management (or a request by management that the lawyer prepare a list) that describes and evaluates pending or threatened litigation, claims, and assessments with respect to which the lawyer has been engaged and to which he has devoted substantive attention on behalf of the company in the form of legal consultation or representation; and

• A list prepared by management that describes and evaluates unasserted claims and assessments that management considers to be probable of assertion, and that, if asserted, would have at least a reasonable possibility of an unfavorable outcome, with respect to which the lawyer has been engaged and to which he has devoted substantive attention on behalf of the company in the form of legal consultation or representation.533

With respect to the information requested in the second paragraph above, the lawyer is requested to furnish, among other things, a description of the matter, the action the company plans to take, “an evaluation of the likelihood of an unfavorable outcome, and an estimate, if

529 SAS 12, at § 4. 530 Id. at § 5. 531 Id. at § 6. 532 In some cases a foreign auditor may send the Inquiry Letter directly to the lawyer. 533 SAS 12, at § 9(a)–(c).


one can be made, of the potential loss.”534 With respect to the third paragraph, the lawyer is requested to disclose if his views “differ from those stated by management.”535

C. ABA Statement

Issued contemporaneously and in tandem with SAS 12, the ABA Statement attempts to balance the attorneys’ need to avoid inadvertent waivers of the attorney-client privilege in responding to the auditors’ letter with the auditors’ need for complete and accurate information in audited financial statements, and addresses the privilege waiver concern as follows:

To the extent that the lawyer’s knowledge of unasserted possible claims is obtained by means of confidential communications from the client, any disclosure thereof might constitute a waiver as fully as if the communication related to pending claims.

A further difficulty arises with respect to requests for evaluation of either pending or unasserted possible claims. It might be argued that any evaluation of a claim, to the extent based upon a confidential communication with the client, waives any privilege with respect to that claim.

Another danger inherent in a lawyer’s placing a value on a claim, or estimating the likely result, is that such a statement might be treated as an admission or might be otherwise prejudicial to the client.

The Statement of Policy has been prepared in the expectation that judicial development of the law in the foregoing areas will be such that useful communication between the lawyers and the auditors in the manner envisaged in the Statement will not prove prejudicial to clients engaged in or threatened with adversary proceedings. If developments occur contrary to this expectation, appropriate review and revision of the Statement of Policy may be necessary.536

The ABA First Report of the Committee on Audit Inquiry Responses Regarding Initial Implementation of the Statement of Policy537 sets forth an illustrative Inquiry Letter prepared in the name of the client pursuant to SAS 12.538

534 Id. at § 9(d)(1), (2). 535 Id. at § 9(e). With respect to unasserted claims, the client must arrive at a judgment that the claim is probable

of assertion, that it would be material, and then identify it in the Inquiry Letter or the lawyer cannot respond because if the does respond, without it being identified in the letter, the lawyer is violating a confidence or secret of the client, which could be an ethical problem for the lawyer.

536 ABA Handbook, supra note 525, at 12–13. 537 The ABA Statement of Policy Regarding Lawyers’ Responses to Auditor’s Request for Information, 31 BUS. LAW.

1709 (Apr. 1976), reprinted in ABA Handbook, supra note 525. 538 ABA Handbook, supra note 525.

Illustrative Form of Letter of Audit Inquiry:


[Name and Address of Law Firm]

Dear Sirs:

In connection with an examination of the consolidated financial statements of [insert name of client] (the “Company”) and its subsidiaries at [insert balance sheet date] and for the [insert fiscal period under audit] then ended, our auditors, [insert name and address of accounting firm], have asked that we request you to furnish them with information concerning certain contingencies involving matters with respect to which you have been engaged and to which you have devoted substantive attention on behalf of the Company and/or any of its subsidiaries. (For your convenience, a list of such subsidiaries is attached.) This request is limited to contingencies which [insert standard of materiality to be used] and they therefore should be considered in connection with our audit.

Pending or Threatened Litigation (excluding Unasserted Claims)

Please furnish to our auditors details relating to all matters of pending or threatened litigation your firm is handling on our behalf, which meet the standard of materiality stated above, including (1) a description of the nature of each matter, (2) the progress of each matter to date, (3) how the Company has responded or intends to respond (for example, to contest the case vigorously or to seek an out-of-court settlement), and (4) an evaluation of the likelihood of an unfavorable outcome and an estimate, if one can be made, of the amount or range of potential loss. Your response should include matters your firm was handling at [insert balance sheet date] as well as new engagements undertaken during the period from that date to the date of your response.

[If one or more unasserted possible claims or assessments are to be listed in the inquiry letter, include the following paragraph. If not, the following paragraph (and caption heading) should be omitted for the reason that the lawyer should be apprised only that management has advised the auditor that management has disclosed to the auditor all unasserted possible claims that the lawyer has advised are probable of assertion and must be disclosed (as specified in FAS 5).]

Unasserted Claims or Assessments

We have informed our auditors that the following unasserted possible claims or assessments, for which you have been engaged and to which you have devoted substantive attention on our behalf in the form of legal consultation or representation, are considered by management to be probable of assertion and which, if asserted, would have at least a reasonable possibility of an unfavorable outcome: [insert information as appropriate; ordinarily, management’s information would include: (1) the nature of the matter, (2) how management intends to respond if the claim is asserted, and (3) an evaluation of the likelihood of an unfavorable outcome and an estimate, if one can be made, of the amount or range of potential loss]. Please furnish to our auditors such explanation, if any, that you consider necessary to supplement the foregoing information including an explanation of those matters as to which your views may differ from those stated.

We understand that whenever, in the course of performing legal services for us with respect to a matter recognized to involve an unasserted possible claim or assessment which may call for financial statement disclosure, if you have formed a professional conclusion that we must disclose or consider disclosure concerning such possible claim or assessment, as a matter of professional responsibility to us, you will so advise us and will consult with us concerning the question of such disclosure and the applicable requirements of Statement of Financial Accounting Standards No. 5. Please specifically confirm to our auditors that our understanding is correct.

Please specifically identify the nature of and reasons for any limitation on your response.

[The auditor may request the client to inquire about additional specific matters; for example, unpaid or unbilled charges or specified information on certain contractually assumed obligations of the Company, such as guarantees of indebtedness of others, for which the addressee of the letter of audit inquiry has been engaged and to which such addressee has devoted substantive attention on the client’s behalf in the form of legal consultation or representation.]

[The letter may also state: “We have represented to our auditors that there have been disclosed by management to them all unasserted possible claims that you have advised are probable of assertion and must be disclosed in accordance with Statement of Financial Accounting Standards No. 5 in the


This Inquiry Letter is the client’s authorization for the lawyer to prepare the lawyer’s Response Letter, which is necessary for the attorney to reveal confidential client information to the auditors under Rule 1.05 of the Texas Disciplinary Rules of Professional Conduct and Rule 1.6 of the ABA Model Rules of Professional Conduct. If the Inquiry Letter is not in proper form, the attorney may discuss the situation with the client and request that the client submit another Inquiry Letter.

Attorney Response Letters under the ABA Statement may come from either an outside practitioner or law firm539 or from inside counsel.540 In each case, the Response letters

financial statements currently under examination.” [or] “We have represented to our auditors that there are no unasserted possible claims that you have advised are probable of assertion and must be disclosed in accordance with Statement of Financial Accounting Standards No. 5 in the financial statements currently under examination.”]

Very truly yours,

_______________ 539 Annex A to the ABA Statement sets forth the following illustrative form of letter to auditors for use by

outside practitioner or law firm:

[Name and Address of Accounting Firm]

Re: [Name of Client] [and Subsidiaries]

Dear Sirs:

By letter dated [insert date of request] Mr. [insert name and title of officer signing request] of [insert name of client] [(the “Company”) or (together with its subsidiaries, the “Company”)] has requested us to furnish you with certain information in connection with your examination of the accounts of the Company as at [insert fiscal year-end].

[Insert description of the scope of the lawyer’s engagement; the following are sample descriptions:]

While this firm represents the Company on a regular basis, our engagement has been limited to specific matters as to which we were consulted by the Company.

[or]

We call your attention to the fact that this firm has during the past year represented the Company only in connection with certain [Federal income tax matters] [litigation] [real estate transactions] [describe other specific matters, as appropriate] and has not been engaged for any other purpose.

Subject to the foregoing and to the last paragraph of this letter, we advise you that since [insert date of beginning of fiscal period under audit] we have not been engaged to give substantive attention to, or represent the Company in connection with, [material]* loss contingencies coming within the scope of clause (a) of Paragraph 5 of the Statement of Policy referred to in the last paragraph of this letter, except as follows:

[Describe litigation and claims which fit the foregoing criteria.]†

[If the inquiry letter requests information concerning specified unasserted possible claims or assessments and/or contractually assumed obligations:]

With respect to the matters specifically identified in the Company’s letter and upon which comment has been specifically requested, as contemplated by clauses (b) or (c) of Paragraph 5 of the ABA Statement of Policy, we advise you, subject to the last paragraph of this letter, as follows:

[Insert information as appropriate]


The information set forth herein is [as of the date of this letter] [as of [insert date], the date on which we commenced our internal review procedures for purposes of preparing this response], except as otherwise noted, and we disclaim any undertaking to advise you of changes which thereafter may be brought to our attention.

[Insert information with respect to outstanding bills for services and disbursements.]

This response is limited by, and in accordance with, the ABA Statement of Policy Regarding Lawyers’ Responses to Auditors’ Requests for Information (December l975); without limiting the generality of the foregoing, the limitations set forth in such Statement on the scope and use of this response (Paragraphs 2 and 7) are specifically incorporated herein by reference, and any description herein of any “loss contingencies” is qualified in its entirety by Paragraph 5 of the Statement and the accompanying Commentary (which is an integral part of the Statement). Consistent with the last sentence of Paragraph 6 of the ABA Statement of Policy and pursuant to the Company’s request, this will confirm as correct the Company’s understanding as set forth in its audit inquiry letter to us that whenever, in the course of performing legal services for the Company with respect to a matter recognized to involve an unasserted possible claim or assessment that may call for financial statement disclosure, we have formed a professional conclusion that the Company must disclose or consider disclosure concerning such possible claim or assessment, we, as a matter of professional responsibility to the Company, will so advise the Company and will consult with the Company concerning the question of such disclosure and the applicable requirements of Statement of Financial Accounting Standards No. 5. [Describe any other or additional limitation as indicated by Paragraph 4 of the Statement.]

Very truly yours,

_______________ Id, at 29–30. * NOTE: See Paragraph 3 of the ABA Statement of Policy and the accompanying Commentary for guidance where the response is limited to material items.

540 Annex A to the ABA Statement also sets forth the following illustrative form of letter for use by inside general counsel:


Re: [Name of Company] [and Subsidiaries]

Dear Sirs:

As General Counsel* of [insert name of client] [(the “Company”] [together with its subsidiaries, the “Company”)], I advise you as follows in connection with your examination of the accounts of the Company as at [insert fiscal year end].

I call your attention to the fact that as General Counsel* for the Company I have general supervision of the Company’s legal affairs. [If the general legal supervisory responsibilities of the person signing the letter are limited, set forth here a clear description of those legal matters over which such person exercises general supervision, indicating exceptions to such supervision and situations where primary reliance upon be placed on other sources.] In such capacity, I have reviewed litigation and claims threatened or asserted involving the Company and have consulted with outside legal counsel with respect thereto where I have deemed appropriate.

Subject to the foregoing and to the last paragraph of this letter, I advise you that since [insert date of beginning of fiscal period under audit] neither I, nor any of the lawyers over whom I exercise general legal supervision, have given substantive attention to, or represented the Company in connection with, [material]** loss contingencies coming within the scope of clause (a) of Paragraph 5 of the Statement of Policy referred to in the last paragraph of this letter, except as follows:

[Describe litigation and claims which fit the foregoing criteria.]

[If information concerning specified unasserted possible claims or assessments and/or contractually


differentiate between unasserted claims and pending litigation.541 As to unasserted claims, the attorneys usually only confirm that they are aware of their professional responsibility not to knowingly participate in any violation by the client of the disclosure requirements of the securities laws and have consulted with the client regarding the client’s disclosure obligations in language like the following:

Consistent with the last sentence of the paragraph 6 of the ABA Statement of Policy, and pursuant to the Company’s request, this will confirm as correct the

assumed obligations is to be supplied:]

With respect to matters which have been specifically identified as contemplated by clauses (b) or (c) of Paragraph 5 of the ABA Statement of Policy, I advise you, subject to the last paragraph of this letter, as follows:


The information set forth herein is [as of the date of this letter] [as of [insert date], the date on which we commenced our internal review procedures for purposes of preparing this response], except as otherwise noted, and I disclaim any undertaking to advise you of changes which thereafter may be brought to my attention or to the attention of the lawyers over whom I exercise general legal supervision.

This response is limited by, and in accordance with, the ABA Statement of Policy Regarding Lawyers’ Responses to Auditors’ Requests for Information (December 1975); without limiting the generality of the foregoing, the limitations set forth in such Statement on the scope and use of this response (Paragraphs 2 and 7) are specifically incorporated herein by reference, and any description herein of any “loss contingencies” is qualified in its entirety by Paragraph 5 of the Statement and the accompanying Commentary (which is an integral part of the Statement). Consistent with the last sentence of Paragraph 6 of the ABA Statement of Policy, this will confirm as correct the Company’s understanding that whenever, in the course of performing legal services for the Company with respect to a matter recognized to involve an unasserted possible claim or assessment that may call for financial statement disclosure, I have formed a professional conclusion that the Company must disclose or consider disclosure concerning such possible claim or assessment, I, as a matter of professional responsibility to the Company, will so advise the Company and will consult with the Company concerning the question of such disclosure and the applicable requirements of Statement of Financial Accounting Standards No. 5 [Describe any other or additional limitation as indicated by Paragraph 4 of the Statement].

Very truly yours,

________ * It may be appropriate in some cases for the response to be given by inside counsel other than inside general counsel in which event this letter should be appropriately modified. ** NOTE: See Paragraph 3 of the ABA Statement of Policy and the accompanying Commentary for guidance where the response is limited to material items.

541 The Preamble to the ABA Statement provides in part:

Consistent with the foregoing public policy considerations, it is believed appropriate to distinguish between, on the one hand, litigation which is pending or which a third party has manifested to the client a present intention to commence and, on the other hand, other contingencies of a legal nature or having legal aspects. As regards the former category, unquestionably the lawyer representing the client in a litigation matter may be the best source for a description of the claim or claims asserted, the client’s position (e.g. denial, contest, etc.), and the client’s possible exposure in the litigation (to the extent the lawyer is in a position to do so). As to the latter category, it is submitted that, for the reasons set forth above, it is not in the public interest for the lawyer to be required to respond to general inquiries from auditors concerning possible claims.

Id. at 6.


Company’s understanding as set forth in the audit inquiry letter to us, that whenever in the course of performing legal services for the Company with respect to a matter recognized to involve an unasserted possible claim or assessment that may call for a financial statement disclosure, we have formed a professional conclusion that the Company must disclose or consider disclosure concerning such possible claim or assessment, we as a matter of professional responsibility to the Company will so advise the Company and will consult with the Company concerning questions of such disclosure and the applicable requirements of Statement of Auditing Standards No. 5.542

The use of “whenever” in a Response Letter is very carefully worded and very carefully chosen by the ABA Committee that developed the Response Letter so that it is not saying we have done this in the past, or that we did this during the last year—it only says whenever necessary will we do it.

If the client does not identify an unasserted claim that the attorney recognizes should be disclosed to the auditors, the attorney would under the preceding paragraph be expected to discuss the issue with the client. If the client declined to authorize the attorney to disclosure in the Response Letter, the attorney would have to consider his duties under Rule 12b2-2 and the SOX § 307 Rules and might have to decline to issue a Response Letter or resign. Ultimately the financial statements, and the information provided to the auditors in connection with the audit thereof, are the responsibility of the client and the attorney’s duty is to advise the client, although the lawyer has a duty not to mislead the auditors.543

As to pending litigation, the attorneys typically include an identification of the case or other proceeding, a brief description of the nature of the litigation or matter, the position asserted or to be asserted by the client, and the current procedural status of the matter. In the evaluation of overtly threatened or pending litigation, paragraph 5 of the ABA Statement states that lawyers should provide an opinion predicting the outcome of overtly threatened or pending litigation only in those relatively few clear cases that the likelihood of an unfavorable

542 Id. at 30. 543 Paragraph 6 of the ABA Statement provides:

(6) Lawyer’s Professional Responsibility. Independent of the scope of his response to the auditor’s request for information, the lawyer, depending upon the nature of the matters as to which he is engaged, may have as part of his professional responsibility to his client an obligation to advise the client concerning the need for or advisability of public disclosure of a wide range of events and circumstances. The lawyer has an obligation not knowingly to participate in any violation by the client of the disclosure requirements of the securities laws. The lawyer also may be required under the Code of Professional Responsibility to resign his engagement if his advice concerning disclosures is disregarded by the client. The auditor may properly assume that whenever, in the course of performing legal services for the client with respect to a matter recognized to involve an unasserted possible claim or assessment which may call for financial statement disclosure, the lawyer has formed a professional conclusion that the client must disclose or consider disclosure concerning such possible claim or assessment, the lawyer, as a matter of professional responsibility to the client, will so advise the client and will consult with the client concerning the question of such disclosure and the applicable requirements of FAS 5.

Id. at 10 (internal citations omitted).


outcome is either “probable” or “remote.”544 The definitions of those terms in paragraph 5 of the ABA statement are narrow definitions, so that, unless the likelihood of an unfavorable outcome of the matters described is either probable or remote, the language that would typically be used in response would be to say with respect to each of the foregoing matters “because we have not concluded that the likelihood of an unfavorable outcome is either probable or remote, as those terms are defined in the ABA statement, we express no opinion as to the likely outcome of such matters.” This is not casual language; “we express no opinion” is not the same as “we have not formed an opinion” or “we cannot form an opinion” or “we decline to express an opinion,” each of which could later be viewed as having predicted that at some point in the future, an opinion would be forthcoming, or might indicate that an opinion has not been formed when in fact there may have been conversations between the lawyer and the client.

D. Discoverability of Audit Response Letters

The Response Letter approach in the ABA Statement is intended to reduce the likelihood of any waiver of privilege as to unasserted claims.545 The ABA Statement is structured such

544 Paragraph 5 of the ABA Statement provides in part:

In view of the inherent uncertainties, the lawyer should normally refrain from expressing judgments as to outcome except in those relatively few clear cases where it appears to the lawyer that an unfavorable outcome is either “probable” or “remote;” for purposes of any such judgment it is appropriate to use the following meanings:

(i) probable - an unfavorable outcome for the client is probable if the prospects of the claimant not succeeding are judged to be extremely doubtful and the prospects for success by the client in its defense are judged to be slight.

(ii) remote - an unfavorable outcome is remote if the prospects for the client not succeeding in its defense are judged to be extremely doubtful and the prospects of success by the claimant are judged to be slight.

If, in the opinion of the lawyer, considerations within the province of his professional judgment bear on a particular loss contingency to the degree necessary to make an informed judgment, he may in appropriate circumstances communicate to the auditor his view that an unfavorable outcome is “probable” or “remote,” applying the above meanings. No inference should be drawn, from the absence of such a judgment, that the client will not prevail.

The lawyer also may be asked to estimate, in dollar terms, the potential amount of loss or range of loss in the event that an unfavorable outcome is not viewed to be “remote.” In such a case, the amount of range of potential loss will normally be as inherently impossible to ascertain, with any degree of certainty, as the outcome of the litigation. Therefore, it is appropriate for the lawyer to provide an estimate of the amount or range of potential loss (if the outcome should be unfavorable) only if he believes that the probability of inaccuracy of the estimate of the amount or range of potential loss is slight.

Id. at 9–10. In the commentary on Paragraph 5, the ABA Statement on page 14 states: “[S]tatements that litigation is being defended vigorously and that the client has meritorious defenses do not, and do not purport to, make a statement about the probability of outcome in any measurable sense.” Id. at 18.

545 See Michael J. Sharp & Abraham M. Stanger, Audit-Inquiry Responses in the Arena of Discovery: Protected by the Work-Product Doctrine, 56 BUS. LAW. 183, 206 (Nov. 2000). This article notes:

In December 1988, the Southern District of New York issued a sealed opinion ordering Drexel’s lawyer to disclose audit-inquiry responses. Unfortunately, because the decision was unpublished


that ordinarily a Response Letter states little more about loss contingencies than what is in the public record, which may explain a paucity of reported cases in which a Response Letter has been held to have resulted in a privilege waiver.546 As to pending litigation, any waiver as to the letter itself would likely not be harmful because the lawyer ordinarily would not be making an assessment of the case which could be construed as an admission against interest. Since a letter regarding pending litigation would be at a time when the work product privilege would be applicable to the litigation work product, and work product waiver ordinarily is limited to the specific documents disclosed,547 a Response Letter to auditors describing the case should not result in the attorney having to turn over the firm’s litigation file to the other side.

There is, however, no consensus among the courts that have addressed the discoverability of Response Letters. Litigants who have been confronted with a discovery request seeking a Response Letter, and who have resisted discovery, have argued attorney-client privilege, work product exclusion, or relevance as bases for refusing to produce the audit response letter.548 A

there is no way of knowing the court’s rationale.

The ABA, however, reacted to the Drexel case. In December 1989, the Subcommittee on Audit Inquiry Responses issued a report on the matter. Writing the report “[b]ecause of a recent court case and other judicial decisions involving lawyer’s responses to auditor’s requests for information,” the Subcommittee chose not to amend the Statement of Policy, but “[i]n order to preserve explicitly the evidentiary privileges” suggested that in the audit-inquiry letter clients state the following: “[W]e do not intend that either our request to you to provide information to our auditor or your response to our auditor should be construed in any way to constitute a waiver of the attorney-client privilege or the attorney work-product privilege.”

To the extent that language is not in the audit-inquiry letter, the Subcommittee suggested insertion of similar language in the audit-inquiry response, “The Company . . . has advised us that . . . [it] does not intend to waive the attorney-client privilege [and] our response to you should not be construed in any way to constitute a waiver of the protection of the attorney work-product privilege. . . .” Two months later, the AICPA, working in conjunction with the ABA Subcommittee, issued its Auditing Interpretations of AU Section 337 (Inquiry of a Client’s Lawyer Concerning Litigation, Claims, and Assessments) to acknowledge such language would not result in a limitation on the scope of an audit.

Id. 546 See Douglas R. Richmond & William Freivogel, The Attorney-Client Privilege and Work Product in the Post

Enron Era, 2004 ABA ANNUAL MEETING PROGRAM MATERIALS, at 11. 547 But cf. United States v. Skeddle, 989 F. Supp. 917, 921 (N.D. Ohio 1997). 548 In Tronitech, Inc. v. NCR Corp., the Court held (i) the audit response letter was not relevant because it was clearly

inadmissible at trial and contained only opinions which could not conceivably lead to admissible evidence, and (ii) while acknowledging that work product protection applies only to materials prepared in anticipation of litigation or for trial, held that an audit letter “is not prepared in the ordinary course of business but rather arises only in the event of litigation,” and therefore constituted work product that was not discoverable. 108 F.R.D. 655 (S.D. Ind. 1985). See also United States v. Arthur Young & Co., No. 84-C-606-B, 1984 U.S. Dist. LEXIS 22991, at *11 (N.D. Okla. Oct. 5, 1984) (noting that “[i]f some theory of relevance can be advanced concerning the documents under review, the Court would conclude its probative value is substantially outweighed by the danger of unfair prejudice and public interest concerns.”); In re Genentech, Inc. v. Securities Litig., No. C-99-4038 (N.D. Cal. 1999) (unpublished) (noting that attorney’s opinions are not relevant or at issue in the lawsuit); Comerica Bank of Calif. v. Lloyd Raymond Free, Case No. 88-20880 (N.D. Cal. 1999) (unpublished) (noting “tangential relevance” of information and finding public policy in favor of protecting attorney’s work-product to be more important); Teberg v. Am. Pacific Int’l, Inc., No. C 196448 (L.A. Sup. Ct., Apr. 29, 1982) (unpublished) (noting that relevance of documents was outweighed by the public policy of promoting candid and full disclosure by counsel to auditor and by the right of privacy). Other courts, when confronted with disputes regarding discovery of lawyer’s responses to auditor’s requests, found the letters to be discoverable. See United States v. Gulf Oil Corp, 760 F.2d 292 (Temp. Emer. Ct. App. 1985) (dismissing a


recent California opinion reviewed the conflicting decisions from other jurisdictions and held that a Response Letter was protected by the work product doctrine,549 reasoning as follows:

Neither party cited nor did we find any California law dealing with the specific question of whether work product loses its protection if it is disclosed to an auditor in an audit response letter. The few cases from federal courts have come down on both sides of this issue. For example, in Tronitech, Inc. v. NCR Corp., the court held an audit response letter was protected by the work product rule because it was comprised solely of an attorney’s opinion. Further, [a]n audit letter is not prepared in the ordinary course of business but rather arises only in the event of litigation. It is prepared because of the litigation, and it is comprised of the sum total of the attorney’s conclusions and legal theories concerning that litigation.

The cases finding against the protection are distinguishable. First, as interpreted in some circuits, the federal work product doctrine is more limited than California’s, with its protection extending only to documents prepared in anticipation of litigation or for trial. . . . In California, however, [t]he protection afforded by the [attorney work product doctrine] is not limited to writings created by a lawyer in anticipation of a lawsuit. It applies as well to writings prepared by an attorney while acting in a nonlitigation capacity. Thus, United States v. Gulf Oil Corp is inapt because the decision not to afford work product protection to audit inquiry responses was based on the finding that the “documents were not created to assist . . . in the litigation. . . .

Moreover, in In re Hillsborough Holdings Corp., the court did not rely on the work product doctrine. The decision to require production of audit inquiry responses was based on the finding that the documents were not protected by the accountant-client privilege.

Thus, based on the contents of the letters, which contain the attorney’s thoughts, impressions, and opinions, plus the purpose of the work product doctrine, and the rule that waiver occurs only when work product is disclosed to a third party who has no interest in maintaining the confidentiality . . . of a significant part of the work product, we conclude Gokoo’s audit response letters to Diehl remained protected work product. Based on our determination on this ground, we have no need to and do not

claim that the audit letters constituted work product by holding “that these documents do not constitute attorney work product because they were created primarily for the business purpose of compiling financial statements which would satisfy the requirements of the federal securities laws”). See also Indep. PetroChemical Corp. v. Aetna Cas. & Sur. Co., 117 F.R.D. 292 (D.D.C. 1987) (holding that any attorney-client privilege associated with the audit response letter was waived when the letter was furnished to the auditor and that the work product exclusion was not applicable); United States v. El Paso Corp., 682 F.2d 530, 543–44 (5th Cir. 1982) (noting that lawyer’s analysis and memoranda “written ultimately to comply with SEC regulations” were prepared “with an eye on [the company’s] business needs, not on its legal ones” and did not “contemplate litigation in the sense required to bring it within the work product doctrine”).

549 Laguna Beach County Water Dist. v. Superior Court of Orange County, 22 Cal. Rptr. 3d 387 (Cal. App. 4th Dist. 2004).


decide the effect of the attorney-client privilege on these two documents. 550

550 Id. at 392–93 (internal citations and quotations omitted). Similar reasoning was followed in Merrill Lynch &

Co., Inc. v. Allegheny Energy, Inc., in which internal investigation reports did not result in a loss of work product protection because they were turned over to independent auditors:

Generally speaking, “the work product privilege should not be deemed waived unless disclosure is inconsistent with maintaining secrecy from possible adversaries.” Stix Prods. v. United Merchants & Mfrs., 47 F.R.D. 334, 338 (S.D.N.Y. 1969). “The work product privilege is not automatically waived by any disclosure to third persons. Rather, the courts generally find a waiver of the work product privilege only if the disclosure ‘substantially increases the opportunity for potential adversaries to obtain the information.’” In re Pfizer Inc. Sec. Litig., 1993 U.S. Dist. LEXIS 18215, No. 90 Civ. 1260, 1993 WL 561125, at *6 (S.D.N.Y. Dec. 23, 1993) (quoting In re Grand Jury, 561 F. Supp. 1247, 1257 (E.D.N.Y. 1982)) (internal citation omitted). Implicit in this analysis is the question of whether the third party itself can or should be considered an adversary. Accordingly, courts have generally held that where the disclosing party and the third party share a common interest, there is no waiver of the work product privilege. E.g., id. (“Disclosure of work product to a party sharing common interests is not inconsistent with the policy of privacy protection underlying the doctrine.”); see also In re Copper Mkt. Antitrust Litig., 200 F.R.D. 213, 221 n.6 (S.D.N.Y. 2001) (same).

This much is settled. However, courts are split in their treatment of disclosures to a corporation’s accountants or auditors. More precisely, courts differ in their conceptualization of two critical points that are often implicitly intertwined in their analysis: whether the "adversary" contemplated by the work product privilege is necessarily a litigation adversary and whether a corporation's auditor is such an adversary, to whom disclosure will waive the privilege. While admittedly there are good arguments on both sides, in this case, I answer both questions in the negative and conclude that Merrill Lynch's disclosure of the reports to Deloitte & Touche did not constitute a waiver of the applicable work product protection.

In a frequently cited case, In re Pfizer, Inc. Sec. Litig., Judge Buchwald held that Pfizer's disclosure of documents to its independent auditor, KPMG Peat Marwick (“Peat Marwick”), did not waive its work product privilege. No. 90 Civ. 1260, 1993 WL 561125, at *6. Judge Buchwald’s decision was based on her observation that “Pfizer and Peat Marwick obviously shared common interests in the information, and Peat Marwick is not reasonably viewed as a conduit to a potential adversary.” Id. Other courts have adopted precisely this analysis. E.g., Gutter v. E.I. Dupont de Nemours & Co., No. 95 Civ. 2152, 1998 WL 2017926, at *5 (S.D. Fla. May 18, 1998) (holding that disclosure to outside accountants did not waive the work product privilege “since the accountants are not considered a conduit to a potential adversary”); Gramm v. Horsehead Indus., Inc., No. 87 Civ. 5122, 1990 WL 142404, at *5 (S.D.N.Y. Jan. 25, 1990) (same). Still others have applied this approach, but scrutinized the precise role of the accountants. E.g., Samuels v. Mitchell, 155 F.R.D. 195, 201 (N.D. Cal. 1994) (deciding that disclosure did not constitute a waiver of the work product privilege because the accounting firm was acting as a consultant, not a “public accountant,” at the relevant time).

Judge Hellerstein articulated another view in Medinol, Ltd. v. Boston Scientific Corp., where, in finding a waiver of the work product privilege, he emphasized the “public watchdog” role of independent auditors. 214 F.R.D. 113, 116 (S.D.N.Y. 2002) (quoting United States v. Arthur Young & Co., 465 U.S. 805, 817-18, 79 L. Ed. 2d 826, 104 S. Ct. 1495 (1984)). Judge Hellerstein observed that it “has become crystal clear in the face of the many accounting scandals that have arisen as of late, in order for auditors to properly do their job, they must not share common interests with the company they audit.” Id. 214 F.R.D. at 116 (emphasis in original). While this is a valid policy consideration, the fact is that the determination in Medinol was based on a finding that the auditor’s interests were not aligned with that of the corporation and that the disclosure of the documents at issue—the Special Litigation Committee’s minutes—did not serve a pertinent litigation interest.

. . .

As these cases make clear, the Court’s inquiry must not end with the mere fact of a disclosure to the independent auditors.

. . .

Instead, the critical inquiry—to me—must be whether Deloitte & Touche should be conceived of as an adversary or a conduit to a potential adversary. As Judge Hellerstein and other courts have


Even though the lawyer’s letter to the auditor may not be protected by the attorney-client privilege, any waiver should be limited to the contents of the letter and should not require the contents of the attorney’s entire file on the matter covered by the letter.551

Auditors often ask for information about loss contingencies beyond Response Letters, and courts often hold that disclosure of attorney-client communications to auditors waives the attorney-client privilege, just as almost any disclosure to an outsider breaches the confidence and waives the attorney-client privilege.552 Thus, unless the controversy arises in one of the fifteen states that, by statute, recognize an accountant-client privilege553 or the accountant is

observed, an independent auditor could be conceived of as an adversary because of its important public function to independently ensure the accuracy of a company’s financial reports. Clearly, outside auditors must maintain an independent role in this regard. Indeed, a good portion of the reforms embodied in the Sarbanes-Oxley Act of 2002 (“Sarbanes Oxley”), 15 U.S.C. § 7201–66, are aimed at strengthening the independence of auditors and eliminating conflicts of interest (S.E.C. Release No. Jan 28, 2003).

. . .

Thus, any tension between an auditor and a corporation that arises from an auditor’s need to scrutinize and investigate a corporation’s records and book-keeping practices simply is not the equivalent of an adversarial relationship contemplated by the work product doctrine. Nor should it be. A business and its auditor can and should be aligned insofar as they both seek to prevent, detect, and root out corporate fraud. Indeed, this is precisely the type of limited alliance that courts should encourage. . . .

There was no further disclosure of the protected material in this case, nor could there have been, as Deloitte & Touche was under an ethical and professional obligation to maintain materials received from its client confidential, unless disclosure was required by law or accounting standards. Gueli Letter, Ex. B P7. The relevant standards at the time in question did not contemplate disclosure of documents or their specific contents to a third party. Instead, if an auditor learned of a “reportable condition,” i.e., an internal control deficiency that “could adversely affect the organization’s ability to record, process, summarize, and report financial data,” AICPA SAS 60.02, the auditor was obligated to report this information to corporate management, the audit committee, and/or the board of directors, AICPA SAS 60.02, .09, .10, AICPA SAS 61. The applicable standard specifically provides that an auditor’s report on a reportable condition should state that it is to be used only by personnel within the corporation, unless the auditor is required to furnish the report to government authorities. AICPA SAS 60.10. The only public revelation could have been, in the worst case scenario, a general statement by Deloitte & Touche regarding its inability to accurately evaluate Merrill Lynch’s financial statements due to internal control deficiencies. In sum, the nature of the disclosure in this case and the obligations of Deloitte & Touche under the applicable accounting standards simply do not make out a waiver.

229 F.R.D. 441, 445–49 (S.D.N.Y. 2004). 551 See United States v. Upjohn Company, 600 F.2d 1223, 1227 n.12 (6th Cir. 1979), rev’d on other grounds, 449

U.S. 383 (1981) (noting “[t]he corporation’s voluntary disclosure to the SEC amounts to a waiver of the privilege only with respect to the facts actually disclosed”).

552 See, e.g., Gutter v. E.I. Dupont De Nemours and Co., No. 95-CV-2152, 1998 WL 2017926, at *3 (S.D. Fla. May 18, 1998) (noting “[d]isclosure to outside accountants waives the attorney-client privilege”); In re Pfizer Inc. Securities Litig., No. 90 Civ. 1260, 1993 WL 561125, at *6 (S.D.N.Y. Dec. 23, 1993) (noting “[d]isclosure of documents to an outside accountant destroys the confidentiality seal required of communications protected by the attorney-client privilege, notwithstanding that the federal securities laws require an independent audit”).

553 The fifteen states that recognize the accountant-client privilege are listed below: Arizona, ARIZ. REV. STAT. § 32-749; Colorado, COLO. REV. STAT. § 13-90-107; Florida, FLA. STAT. ANN. § 90.5055; Georgia, GA. CODE ANN. § 43-3-32; Idaho, IDAHO CODE § 9-203A AND IDAHO ST. REV., Rule 515; Illinois, 225 ILL. COMP. Stat. 450/27; Indiana, IND. CODE. § 34-46-2-18; Kansas, KS. STAT. ANN. § 1-401; Louisiana, LA. CODE EVID. ANN. art. 515; Maryland, MD. CODE ANN., CTS. & JUD. PROC. § 9-110; Michigan, MICH. COMP. LAWS § 339.732; Missouri, MO. REV. STAT. § 326.322; New Mexico, N.M. STAT. ANN. § 38-6-6; Pennsylvania, PA. STAT. ANN. tit. 63


helping the attorney to advise the client (a role that an auditor typically does not undertake given independence constraints), disclosure to the outside accountant likely waives the attorney-client privilege.554 With respect to whether work product protection survives disclosure to auditors, the opinions are divided, but the majority view seems to be that work product includes any material prepared “because of” actual or potential litigation (thus encompassing analysis of litigation exposure prepared in response to an Inquiry Letter) and survives disclosure to the auditors.555 The forum in which the discoverability issues are litigated, as well as particular circumstances of the case, will determine whether the protection otherwise applicable will survive disclosure to auditors. 556 Companies, therefore, have no

§ 9.11; and Tennessee, TENN. CODE ANN. § 62-1-116. Other states have statutes requiring accountants and auditors to maintain the confidentiality of client materials, but not purporting to establish any evidentiary privilege from discovery. See Alabama, ALA. CODE § 34-1-21; California, 16 CAL. CODE REGS. tit. 16, § 54 ; Connecticut, CONN. GEN. STAT. ANN. § 20-281j; Iowa, IOWA CODE ANN. § 542.17; Kentucky, KY. REV. STAT. ANN. § 325.440; Massachusetts, MASS. GEN. LAWS ANN. ch. 112 § 87E; Minnesota, MINN. STAT. ANN. § 326A.12; Mississippi, MISS. CODE. ANN. § 73-33-16; Montana, MONT. CODE. ANN. § 37-50-402; New Jersey, N.J. STAT. ANN. § 45:2B-65; North Dakota, N.D. CENT. CODE § 43-02.2-16; Oregon, OR. REV. STAT. § 673.385; Rhode Island, R.I. GEN. LAWS § 5-3.1-23; Vermont, VT. CODE R. § 81; Washington, WASH. REV. CODE

ANN. § 18.04.405. 554 See Ferko Nat’l Assoc. for Stock Car Auto Racing, 218 F.R.D. 125, 134–35 (E.D. Tex. 2003) (citing United

States v. Kovel, 296 F.2d 918, 921–22 (2d Cir. 1961) (extending the attorney client privilege to attorney-accountant communications for the purpose of assisting the lawyer to advise the client)).

555 See United States v. Adlman, 134 F.3d 1194, 1202 (2d Cir. 1998) (observing, in dicta, that the work-product doctrine would protect an audit-inquiry response and approving the rule adopted by the Third, Fourth, Seventh, Eighth, and D.C. Circuits that a document is work product if “in light of the nature of the document and the factual situation in the particular case, the document can fairly be said to have been prepared or obtained because of the prospect of litigation”) (emphasis in original); In re Honeywell Int’l, Inc. Securities Litig., No. M8-85, 2003 WL 22722961, at *6 (S.D.N.Y. Nov. 18, 2003) (rejecting plaintiff’s argument that the “preeminent business purpose” of an audit rendered the work product doctrine inapplicable and finding that defendant’s “assertion of work product protection for . . . audit letters and litigation reports prepared by its internal and external counsel, as well as PWC documents memorializing . . . opinion work product, is proper.”); Southern Scrap Material Co. v. Fleming, No. 01-2554, 2003 WL 21474516, at *9 (E.D. La. June 18, 2003) (noting “[t]he audit letters . . . were prepared by outside counsel at the request of [party’s] general counsel with an eye toward litigation then ongoing. [Thus] they are attorney work product of the opinion/mental impression/litigation strategy genre.”); In re Raytheon Securities Litig., 218 F.R.D. 354 (citing cases in the Third, Fourth, Seventh, Eighth and D.C. Circuits that have adopted the “because of” definition of work product); Vanguard Sav. and Loan Ass’n. v. Barton Banks, No. 93-CV-4627, 1995 U.S. Dist. LEXIS 13712, at *11-12 (E.D. Pa. 1995) (holding that lawyer letters regarding litigation, prepared to assist client in reporting loss contingencies for a regulatory examination, were work product and protected even though created “primarily” for a business purpose); Tronitech, Inc. v. NCR Corp., 108 F.R.D. 655, 657 (S.D.Ind. 1985) (noting “an audit letter is not prepared in the ordinary course of business but rather arises only in the event of litigation. It is prepared because of the litigation . . . [and] should be protected by the work product privilege”).

556 Compare Medinol, Ltd. v. Boston Scientific Group, 214 F.R.D. 113, 115 (S.D.N.Y. 2002) (noting minutes of the Special Litigation Committee meeting reflecting counsel’s investigation were provided to the auditors in connection with their audit of loss contingency reserves—the court held that the disclosure waived the work product protection), with Gramm v. Horsehead Indus., Inc., No. 87 Civ. 5122 (MJL), 1990 U.S. Dist. LEXIS 773, at *19 (S.D.N.Y. Jan. 25, 1990) (finding no waiver upon disclosure to auditors because “disclosure to another person who has an interest in the information but who is not reasonably viewed as a conduit to a potential adversary will not be deemed a waiver of protection of the rule”); Tronitech, 108 F.R.D. at 657 (finding no waiver upon disclosure of work product to auditors since “audit letters are produced under assurances of strictest confidentiality”). See Merrill Lynch & Co., Inc. v. Allegheny Energy, Inc., 229 F.R.D. 441 (S.D.N.Y. 2004) and cases discussed therein.


guarantee that courts will protect the work product generated from internal investigations from waiver as to adversaries if these materials are disclosed to auditors, and could complain: “[a]n uncertain privilege, or one which purports to be certain but results in widely varying applications by the courts, is little better than no privilege at all.”557

X. SELECTED RESPONSE LETTER ISSUES

A. Is the ABA Statement Superseded by SOX § 303?

Concern has been expressed as to whether compliance with the ABA Statement will protect the lawyer in view of the SOX § 303 Requirements. The ABA Statement has not been superseded by the SOX § 303 Requirements. In a situation where no estimate of outcome is given in the audit response because the likelihood of a unfavorable outcome is considered neither “remote” or “probable,” but the lawyer has in fact developed the view that the likelihood of an unfavorable outcome is significant (but short of “probable”), could the response be said to be misleading on the basis that it fails to state a material fact? The lawyer’s communication would be within the framework of the ABA Statement that established clear standards for what will and will not be included in the Response Letters.

A Response Letter conforming to the ABA Statement delivered to accountants who were parties to the professional treaty memorialized in the ABA Statement should not be misleading to the accountants to whom it is addressed since (i) they know the basis on which it was prepared and (ii) the Response Letter states the framework under which it was prepared. If, however, the Response Letter does not conform to the ABA Statement or the attorney has oral communication with the auditors, the attorney would not be responding within the framework of the ABA Statement and would have the risk of negligent advice which would be sanctionable under Rule 13b2-2 of the 1934 Act.

Further, the attorney has a duty to consult with the client regarding unasserted material loss contingencies not disclosed in the Response Letter which the attorney believes the client should disclose or consider disclosing. If the client does not respond appropriately, the lawyer would have to comply with the lawyer’s reporting up the ladder obligation under the rules under SOX § 307 described below or consider whether to resign or decline to deliver a Response Letter. An attorney could also have exposure under common law or applicable securities laws for an improper Response Letter.558

B. The Company Dilemma

The ABA Statement cautions that the lawyer “should normally refrain from expressing judgments as to outcome except in those relatively few clear cases where it appears to the

557 Upjohn Co. v. United States, 449 U.S. 383, 391 (1981). 558 Cf. In re Enron Corp. Sec., Derivative and ERISA Litig., 235 F. Supp. 2d 549, 563 (S.D. Tex. 2002)

(containing Memorandum and Order Re Secondary Actors’ Motion to Dismiss filed December 20, 2002). The opinion (also known as Newby v. Enron or the Newby case) is 159 pages long. Cf. Dean Foods Co. v. Pappathanasi, 18 Mass. L. Rep. 598, 2004 WL 3019442 (Mass. Super. Dec. 3, 2004); Donald W. Glazer & Arthur Norman Field, No-litigation Opinions Can Be Risky Business: Looking at the Facts—and Beyond, 14 BUS. L. TODAY No. 6, July/Aug. 2005, at 37.


lawyer that an unfavorable outcome is either ‘probable’ or ‘remote’.” However, what if the auditor asserts that the attorney must provide an evaluation by reason of SOX § 303? The attorney representing the company faces the following unattractive choices. If the attorney provides an evaluation, it may be asserted that it is a waiver of the attorney-client privilege or work product protection that might under normal circumstances insulate the information from third party discovery.559 Moreover, if the privilege or protection is waived, it is potentially waived for all purposes and as to all third parties.560 Although it is far from clear that a waiver would be found, this potential could be a very high price to pay with respect to the pending case or claim.

Further, if the attorney decides or is instructed by the company to provide information beyond that specified in the ABA Statement, the nonconforming communication could expose the attorney to enforcement action under the SOX § 303 Requirements if the case or claim ultimately results in a material exposure relative to the assets of the company which was not foreseen at the time of the attorney communication. In this regard, the SEC has already indicated that one type of conduct that could result in rendering an issuer’s financial statements materially misleading would be providing an auditor with an inaccurate or misleading response or legal analysis. The SEC has also indicated that responsibility for a misleading response or analysis falls on the attorney providing information to the auditor.561 Thus, if the case or claim results in a material adverse judgment or settlement, the attorney (particularly in the case of an inside attorney acting under the direction of, or based on information supplied by, the company general counsel or its chief financial officer or their designee(s)) could be asserted to have been responsible, as may be those supplying the information or direction, for “misleading” the auditor. This is not a very attractive situation and one which could also result in significant personal exposure to the responsible parties.

As a practical matter, the dilemma described above is most likely to arise in relatively large, complex cases or claims of potential material significance, particularly in circumstances in which it may be too early in the proceedings to form a solid conclusion as to whether the matter is in the “probable” or “remote” category for purposes of the ABA Statement. What is clear in such situations is the need for close and continuous consultation between outside lawyers representing the company and the general counsel, chief financial officer, or their designee(s). There is unquestionably a need to develop a “good faith” consensus among the issuer and its attorneys on responses to any auditor request for information and to maintain consistency throughout the process of interaction with the auditor, while not undermining the independence of the attorney’s professional judgment. This process may also include requests for estimates of loss, requests beyond the ABA Statement, updates, informal discussions, and information as to specific cases. These issues are discussed in greater detail in the material that follows.

Thus, while the ABA Statement remains in full force and effect, the risks associated with responses in connection with potentially material cases or claims that have not matured to the

559 See infra Exhibit A Attorney-Client Privilege and the Work Product Doctrine in the Corporate Context. 560 Id. 561 See supra notes 414–21 and related text.


point of being able to be categorized as either “probable” or “remote” must be considered in view of SOX § 303 Requirements. Ideally, the policy importance of protecting the attorney-client and work product privileges will be recognized in appropriate situations; however, the likelihood is that barring further legislative or regulatory clarification, the contours of such risks of waiver as well as of enforcement attitudes, will be defined over some time and on a case-by-case basis.

C. Law Firm Policies

Many law firms have adopted policies and procedures for processing Inquiry Letters and issuing Response Letters which typically are based on the ABA Statement.562 Law firms typically have adopted policies for circulating information to its attorneys that the client’s Inquiry Letter has been received and soliciting information needed to complete the Response Letter. Some firms designate a particular individual or committee to respond to questions or to review all or particular kinds of Response Letters. Before undertaking to respond to an Inquiry Letter or work on a Response Letter, attorneys should become familiar with the ABA Statement and the firm’s policies and procedures.

D. Estimates of Loss

With respect to opinions as to outcome and estimates of potential loss, each lawyer should carefully read and consider Paragraph 5 of the ABA Statement. There the lawyer is cautioned that the lawyer “should normally refrain from expressing judgments as to outcome except in those relatively few clear cases where it appears to the lawyer that an unfavorable outcome is either ‘probable’ or ‘remote,’” using such terms in accordance with their meanings set forth in Paragraph 5 and the related Commentary. It should be noted that a lawyer is not in a position to express an opinion that the likelihood of an unfavorable outcome is “remote” unless in the lawyer’s “unqualified judgment, taking into account all relevant facts which may affect the outcome, . . . the client may confidently expect to prevail on a motion for summary judgment on all issues due to the clarity of the facts and the law.” Likewise, the lawyer should not attempt to estimate, in dollar terms, the potential amount of loss or range of loss in the event of an unfavorable outcome unless the lawyer believes that the probability of inaccuracy of the estimate is slight. In practical terms, in a situation involving an unliquidated claim or demand, attorneys should rarely if ever make a loss estimate. Unless the likelihood of an unfavorable outcome is probable or remote, within the meaning of the ABA Statement, a typical response to an inquiry concerning outcome and the amount or range of potential loss is the following:

Because we have not formed a conclusion as to whether an unfavorable outcome is either probable or remote (as those terms are defined in the ABA Statement), we express no opinion with respect to the likelihood of an unfavorable outcome or the amount or range of potential loss if the outcome should be unfavorable.

The language used when declining to state an opinion as to outcome can be important and should track the wording and structure of the ABA Statement. To state “we are unable to

562 Attached as Exhibit B is a common form of law firm Response Letter.


express an opinion” may be inadvisable because it does not track the structure of the ABA Statement, and could be misleading if the attorney in fact has formed an opinion. Similarly, keying the non-expressing of an opinion as to outcome to the case being in the early stages of litigation should be avoided, as arguably it could be construed to create a duty to update which is contrary to other wording in the Response Letter. Language that is keyed to the language of the ABA Statement, such as “because we have not formed a conclusion as to whether an unfavorable outcome is either probable or remote (as those terms are defined in the ABA Statement), we express no opinion as to the likelihood of an unfavorable outcome” should be good practice.

E. Requests Beyond Scope of ABA Statement

Ordinarily, the Response Letter should include only information as to loss contingencies as permitted by the ABA Statement and, if requested, information as to fees and disbursements owed by the client. As a result of the pressures on auditors to be more thorough in their audit procedures and documentation,563 some Request Letters ask for information about other

563 SEC Deputy Chief Accountant Scott A. Taub summarized the SEC’s concerns that the audit process adequately address accruals for and disclosures of loss contingencies, including obtaining appropriate information from counsel, in the following remarks delivered at the University of Southern California Leventhal School of Accounting:

I am well aware that loss contingencies are one of the most difficult areas there is to audit. Representations from management and from attorneys sometimes seem to be all that there is to support an accrual or the lack of one. The difficulty in auditing these types of accruals, however, should cause the auditor to spend more time on them, not less. Auditors should seek to review the company’s own analyses of the issues, including the support for the conclusions as to whether an accrual is necessary, and what the possible range of loss is. If the only procedures that can be performed are face-to-face discussions with company personnel and with outside counsel, those discussions should be held, and experienced auditors should be part of them. If a company’s outside counsel is unwilling or unable to provide its expert views, the auditor should consider whether sufficient alternate procedures can actually be performed to allow the audit to be completed. Audit documentation should follow the same high standards that apply to other areas of the audit, as well. This, of course, includes the documentation of the audit of the tax contingency accounts. A note or short memo that indicates that qualified personnel from the audit firm held discussion of all relevant risks with company personnel is not sufficient. I would expect that the PCAOB inspection teams will be looking at the audit work done in these sensitive areas as they begin their first year of a full inspection schedule.

Scott A. Taub, Deputy Chief Accountant, Securities and Exchange Commission, Speech at University of Southern California Leventhal School of Accounting SEC and Financial Reporting Conference (May 27, 2004), available at http://www.sec.gov/news/speech/spch052704sat.htm. On August 26, 2004, in a limited inspection report on one of the largest accounting firms, the PCAOB criticized the firm for instances of inadequate support regarding the treatment of contingent liabilities under FAS 5, including:

With respect to a potential contingent liability, the engagement team obtained a memo from the issuer that documented the company’s conclusions regarding the loss contingency, and the engagement team documented in a memo to the work papers its conclusion that no accrual for this liability was required as of a particular date. The memo documented that the contingent liability could arise from two default provisions in an existing agreement—currently known defaults by the company or future potential defaults based on operating decisions the company was contemplating. The memo and the disclosures in the financial statements indicated that management’s conclusion that an accrual was not required was based on the advice of legal counsel. The work papers maintained by the U.S. engagement team, however, did not include a copy of a letter to the issuer from its counsel containing legal advice on which the issuer had based its conclusions. Nor did the work papers make any specific reference to such a letter being maintained elsewhere. The work papers also did not provide a clear assessment as to the basis, as between the competing alternative


matters, such as security agreements, the filing of financing statements, outstanding stock, legislative developments, compliance with environmental laws, securities laws or ERISA, violations of laws or codes of conduct, or fiduciary duties or changes in business practices. One form of non-standard Inquiry Letter asks the law firm to confirm in the Response Letter that any possible illegal acts of the company that the law firm knows of have been reported to the company’s audit committee and auditors. Since attorneys cannot be assured that auditors will conform to the Inquiry Letter format contemplated by the ABA Statement or to the form of Inquiry Letter issued for the same client in prior years, attorneys will need to consider each Inquiry Letter individually for particular issues of non-conformity with the ABA Statement. These non-standard Inquiry Letters typically do not reflect sensitivity to the importance of avoiding waiver of the attorney-client privilege.564

Attorneys often decline to supply information in a Response Letter beyond what is contemplated by the ABA Statement, and generically comment that such other information is not being provided.565 Some commentators suggest that, in addition, it is appropriate to specifically reference the requested information not being furnished and state that it is not being provided because the request is beyond the scope of the ABA Statement in order that there be no ambiguity that the non-conforming request is being denied.566 Attorneys should understand, however, that the auditors’ requests for the additional information may be based upon a real need for corroborative information to complete their audit procedures and that there are circumstances in which the auditors’ inability to obtain the requested additional

bases, for the conclusion that accrual of the potential contingent liability was not required.

Report on 2003 Limited Inspection of Deloitte & Touche LLP (PUB. ACCOUNTING OVERSIGHT BD. Aug. 26, 2004), at 21, available at http://www.pcaobus.org/Inspections/Public_Reports/2003/Deloitte_and_Touche.pdf.

564 In a Report to the ABA House of Delegates by an ABA Task Force on Attorney-Client Privilege, it was noted:

The AICPA interpretations of SAS No. 12 (AU Section 337.09) also recognize the importance of the attorney-client privilege by limiting the need to examine documents in the company’s possession that are subject to the privilege. Recently, however, with increasing frequency, auditors have requested from companies privileged communications or attorneys’ litigation work product. The Task Force has been made aware of several types of material that auditors are requesting that companies provide for audits. Examples of the requested material include (1) tax opinions prepared for companies by outside counsel that underlie tax positions and tax accruals; (2) assessments prepared by both in-house and outside counsel that relate to litigation accruals and set forth counsel’s reasoning underlying such accruals; (3) reports and papers produced as a result of internal investigations regardless of whether such investigations are ongoing or are likely to have an impact upon an audit; and (4) materials related to compliance with legal and regulatory requirements, e.g., requests to see board and committee members’ annual self-assessments.

Report of the American Bar Association’s Task Force on the Attorney-Client Privilege, 60 BUS. LAW. 1029, 1053 (May 2005), available at http://www.abanet.org/buslaw/attorneyclient/. See supra notes 545–57 and related text.

565 The second paragraph of a typical Response Letter provides:

This response is limited by, and is in accordance with, the ABA Statement of Policy Regarding Lawyers’ Responses to Auditors’ Requests for Information (December, 1975) and the accompanying Commentary (collectively, the “ABA Statement of Policy”). We are not responding to any request, nor are we commenting on any statement, contained in the Request Letter which we believe to be inconsistent with the intent of the ABA Statement of Policy. No inference should be drawn from our failure to respond to or comment on any such request or statement.

ABA Handbook, supra note 525, at 32. 566 See Ad Hoc Committee on Audit Responses: Report on Listserv Activity (Inception to August 3, 2004), ABA

SECTION OF BUSINESS LAW AD HOC COMMITTEE ON AUDIT RESPONSES.


information could lead the auditors to qualify opinions on clients’ financial statements, which could be worse for the clients than the consequences of giving the auditors the information they require. For example, in circumstances in which the auditor believes that it needs the attorney’s response about illegal acts in order to satisfy the auditor’s § 10A obligations, there may need to be communications from a reliable source sufficient to satisfy the auditor’s requirements.

Some Inquiry Letters include a request beyond the scope of the ABA Statement in the form of a general inquiry regarding unasserted claims. Since under the ABA Statement a request for comment about unasserted claims is appropriate only if the client has determined that it is probable that a claim will be asserted, that there is a reasonable possibility that the outcome (assuming the claim is asserted) will be unfavorable, and that the resulting liability would be material, some lawyers specifically note in their Response Letter the general inquiry and the inappropriateness under the ABA Statement of responding to it. Others rely on the general incorporation by reference of the ABA Statement into the Response Letter as sufficient explanation as to why there is no response to a non-standard general inquiry regarding unasserted claims.

F. Requests for Updates or Informal Discussions

The constraints on what may be said in Response Letters under the ABA Statement sometimes lead to requests for informal discussions in which supplemental information is elicited from the lawyer. The ABA Statement does not envision informal sessions with auditors or otherwise provide any parameters for what may be communicated to auditors in such a context different from those applicable to a formal response. While many law firms discourage or even forbid such discussions because of the risks of miscommunication or misunderstanding567 or inadvertent waiver of privilege, auditors may insist that they require such discussions or written representations as a prerequisite to expressing an unqualified opinion on the client’s financial statements. When and if an attorney enters into such a discussion, he can expect that his oral statements will be summarized in auditors’ notes and workpapers, which the attorney will not have an opportunity to review or correct.

Auditors often ask for updated Response Letters. Providing an updated Response Letter requires that the firm’s internal search process be repeated, and is often discouraged for cost and timing reasons.

Auditors sometimes request updates via telephone. Attorneys often respond that responses to auditor requests for information should be in accordance with the ABA Statement, which does not contemplate oral updates. Further, an update requires reinitiation of the firm search process, which takes time and costs the client money. Nonetheless, if the auditors conclude that they need an update as a prerequisite for an unqualified opinion on the financial statements, the client may ask the attorneys to perform the appropriate procedures to provide

567 See the discussion of SEC Rule 13b2-2, supra, notes 411–17 and related text, and Google, Inc. Securities Act

Release No. 8523, supra note 441, in which the general counsel of Google consented to a cease and desist order as a result of giving erroneous advice to Google regarding disclosures required to be given to employees to whom employee stock options were granted.


an updated Response Letter.

G. Information as to Specific Cases

On occasion an auditor will advise the client that the typical “we express no opinion” as to outcome or amount or range of loss is unsatisfactory and will advise the client that the significance of the case requires further guidance from the lawyer or the auditor will have to qualify the auditor’s opinion as to the financial statements. In such a case the attorney is permitted by the ABA Statement to provide additional information. Since predictions as to the outcome of litigation are fraught with peril for both the client and the lawyer, the client’s disclosure position does not justify a deviation from the principles of the Statement as to predictions as to outcome or loss exposure.

H. Inside Counsel Special Issues

The ABA Statement applies to both inside and outside counsel, and includes a form of response letter for an inside general counsel568 that is similar to the form for outside counsel,569

568 Annex A to the ABA Statement also sets forth the following illustrative form of letter for use by inside general counsel:


Re: [Name of Company] [and Subsidiaries]

Dear Sirs:

As General Counsel* of [insert name of client] [(the “Company”] [together with its subsidiaries, the “Company”)], I advise you as follows in connection with your examination of the accounts of the Company as at [insert fiscal year end].

I call your attention to the fact that as General Counsel* for the Company I have general supervision of the Company’s legal affairs. [If the general legal supervisory responsibilities of the person signing the letter are limited, set forth here a clear description of those legal matters over which such person exercises general supervision, indicating exceptions to such supervision and situations where primary reliance upon be placed on other sources.] In such capacity, I have reviewed litigation and claims threatened or asserted involving the Company and have consulted with outside legal counsel with respect thereto where I have deemed appropriate.

Subject to the foregoing and to the last paragraph of this letter, I advise you that since [insert date of beginning of fiscal period under audit] neither I, nor any of the lawyers over whom I exercise general legal supervision, have given substantive attention to, or represented the Company in connection with, [material]** loss contingencies coming within the scope of clause (a) of Paragraph 5 of the Statement of Policy referred to in the last paragraph of this letter, except as follows:

[Describe litigation and claims which fit the foregoing criteria.]

[If information concerning specified unasserted possible claims or assessments and/or contractually assumed obligations is to be supplied:]

With respect to matters which have been specifically identified as contemplated by clauses (b) or (c) of Paragraph 5 of the ABA Statement of Policy, I advise you, subject to the last paragraph of this letter, as follows:


The information set forth herein is [as of the date of this letter] [as of [insert date], the date on which


although the inside counsel form differs in its description of the attorney’s capacity and does not refer to an Inquiry Letter since the attorney is employed by the company. Some inside counsel use adaptations of this Treaty form of Response Letter, while others who were formerly with law firms use essentially the same form of Response Letter as when they were in private practice. Others will coordinate the receipt of Response Letters from outside counsel and deliver them to the auditors with a letter to the effect that they are not aware of any threatened or pending litigation not referenced in the outside counsel Response Letters. In some cases, inside counsel will deal with pending and threatened litigation in a representation letter structured much like a typical Response Letter, while in other instances the representation letter looks more like a typical management representation letter to auditors.

Whatever the form of the inside attorney written communication to the auditors, the auditors are increasingly pressing for inside counsel to provide much more detail as to the expected outcome of the cases and seeking to tie those evaluations to the loss reserves, if any, established by management for the cases. Often inside counsel, irrespective of how they respond to the auditors in writing, will meet with the auditors to discuss pending and threatened litigation and there will be candid discussions regarding the loss reserves established by management, the risks seen in particular cases and inside counsel’s views as to the likely outcome of the case. Those communications are not protected by the ABA Statement, and expose the inside attorney to charges under SOX § 303 if the information given ultimately proves incorrect and misleads the auditors.570

we commenced out internal review procedures for purposes of preparing this response], except as otherwise noted, and I disclaim any undertaking to advise you of changes which thereafter may be brought to my attention or to the attention of the lawyers over whom I exercise general legal supervision.

This response is limited by, and in accordance with, the ABA Statement of Policy Regarding Lawyers’ Responses to Auditors’ Requests for Information (December 1975); without limiting the generality of the foregoing, the limitations set forth in such Statement on the scope and use of this response (Paragraphs 2 and 7) are specifically incorporated herein by reference, and any description herein of any “loss contingencies” is qualified in its entirety by Paragraph 5 of the Statement and the accompanying Commentary (which is an integral part of the Statement). Consistent with the last sentence of Paragraph 6 of the ABA Statement of Policy, this will confirm as correct the Company’s understanding that whenever, in the course of performing legal services for the Company with respect to a matter recognized to involve an unasserted possible claim or assessment that may call for financial statement disclosure, I have formed a professional conclusion that the Company must disclose or consider disclosure concerning such possible claim or assessment, I, as a matter of professional responsibility to the Company, will so advise the Company and will consult with the Company concerning the question of such disclosure and the applicable requirements of Statement of Financial Accounting Standards No. 5 [Describe any other or additional limitation as indicated by Paragraph 4 of the Statement].

Very truly yours,

______________ ABA Handbook, supra note 525, at 29–30. * It may be appropriate in some cases for the response to be given by inside counsel other than inside general counsel in which event this letter should be appropriately modified. ** NOTE: See Paragraph 3 of the ABA Statement of Policy and the accompanying Commentary for guidance where the response is limited to material items.

569 See infra the form of outside counsel Response Letter attached as Exhibit A. 570 See supra notes 414–21 and related text.


I. Triangle

The preparation of client financial statements involves at least three directions of communication: (1) client with auditor, (2) attorney with client, and (3) attorney with auditor. The most significant side of this triangle is the communication between the client and its auditors, for the financial statements are those of the client and report on its financial position and results of operations, and the auditor, which is performing specified processes in order to issue an opinion or report thereon. The Response Letter is the most typical attorney communication with the auditors and the formalized way that the ABA Statement contemplates attorneys are to provide information to the auditors as they pursue their processes in respect of the client financial statements. The Response Letter with respect to the sensitive subject of unasserted claims typically contains an attorney undertaking to communicate with the client that includes the following:

Consistent with the last sentence of the paragraph 6 of the ABA Statement of Policy, and pursuant to the Company’s request, this will confirm as correct the Company’s understanding as set forth in the audit inquiry letter to us, that whenever in the course of performing legal services for the Company with respect to a matter recognized to involve an unasserted possible claim or assessment that may call for a financial statement disclosure, we have formed a professional conclusion that the Company must disclose or consider disclosure concerning such possible claim or assessment, we as a matter of professional responsibility to the Company will so advise the Company and will consult with the Company concerning questions of such disclosure and the applicable requirements of Statement of Auditing Standards No. 5.571

Communications by attorneys with their clients need to be made with sensitivity to client disclosure obligations under applicable securities laws and to attorney professional responsibilities under applicable state ethics rules and SOX § 307 Rules.

J. Gain Contingencies

Both the foregoing discussion and the ABA Statement focus on loss contingencies, but companies may also seek to recover damages or other relief from third parties as a plaintiff. Some Inquiry Letters may request information regarding “contingencies,” rather than “loss contingencies,” or may frame the inquiry relating to overtly threatened or pending litigation in the form of a request such as: “Please furnish our auditors with a description of all pending or threatened litigation that you are handling on our behalf” and ask for “an evaluation of the likelihood of an unfavorable outcome,” suggesting that the disclosable items are not limited to “loss” contingencies arising from pending or threatened litigation against the company.572 Attorneys generally read “contingencies” in such letters in the context of the ABA Statement,

571 ABA Handbook, supra note 525, at 30. 572 FAS 5 provides at Paragraph 17b: “Adequate disclosure shall be made of contingencies that might result in

gains, but care shall be exercised to avoid misleading implications as to the likelihood of realization.” SFAS 5, supra note 524. Footnote disclosure thus may be required of material gain contingencies. Accruals are not made for gain contingencies.


which clearly deals with “loss” contingencies, and deliver a standard Response Letter based on the Treaty.573 In such a case, it may be desirable for the attorney to consider whether the company’s assertion of claims is likely to lead to the assertion of counter or cross-claims that either need to be disclosed as overtly threatened claims or considered as unasserted claims likely of assertion, although the attorney should not have a duty to address the possibility of counter or cross-claims in a Response Letter in the absence of facts which would support the reference under a traditional unasserted claims analysis.

Other attorneys interpret “contingencies” to include not only claims against the client, but also claims by the client, and then proceed to respond in accordance with Treaty guidelines.574 The August 1976 Second Report of the Committee on Audit Inquiry Responses Regarding Internal Implementation of the Statement of Policy recognized that it would be appropriate for counsel to respond to inquiries regarding gain contingencies as follows:

Historically, the auditor’s concern, in his inquiry directed to the lawyer, has been limited to contingent liabilities. With the advent of FAS 5, this focus has been upon litigation claims and assessments with present loss contingencies. In this connection, the Financial Accounting Standards Board continued in effect the provisions of Accounting Research Bulletin No. 50 regarding contingent assets. Paragraph 17 of FAS 5 provides that:

a) Contingencies that might result in gains usually are not reflected in the accounts since to do so might be to recognize revenue prior to its realization.

b) Adequate disclosure shall be made of contingencies that might result in gains, but care shall be exercised to avoid misleading implications as to the likelihood of realization.575

Given the orientation of the auditing and accounting professions to disclosure considerations as they relate to loss contingencies, the ABA Statement of Policy deals only with the subject of loss contingencies (i.e., litigation, claims, and assessments where the client’s involvement is as a defendant or prospective defendant). However, footnote 2 to SAS No. 12 does refer to the auditor’s procedures with respect to gain contingencies; and, consistent therewith, some auditors have concluded that logic compels a better balanced presentation of contingencies, whether they are loss contingencies or gain contingencies, and

573 Where counsel is not addressing a request that would encompass gains contingencies, some Response Letters

express such limitations in language such as the following:

Our response deals only with the subject of loss contingencies (i.e., litigation, claims, and assessments where the Company’s involvement is as a defendant or prospective defendant) and not with matters in which we represent the Company as claimant or as plaintiff in which no litigation has been asserted against the Company or other matters (except billing information where requested in the Company’s Inquiry letter).

Such a response also does not address uncollectible receivables or other forms of asset impairment beyond the type of loss contingencies identified in the Treaty.

574 James J. Fuld, Lawyers’ Responses to Auditors-Some Practical Aspects, 44 BUS. LAW 159, 162 (Nov. 1988). 575 SFAS 5, supra note 524. See Second Report of the Committee on Audit Inquiry Responses Regarding

Internal Implementation of the Statement of Policy, 32 BUS. LAW 43, 51 (Nov. 1976).


have therefore solicited information, in the audit inquiry letter, with respect to matters in which the lawyer is acting on behalf of the client where the client is either plaintiff or defendant.

When the audit letter solicits such additional information, it is not improper for the lawyer to respond, but his response should be within the limits established by the ABA Statement of Policy. In this connection, it should be noted that there may be gain contingencies of such a material nature that they should be the subject of disclosure in financial statements and, in some instances, the auditor may conclude it appropriate or necessary to make the audit opinion “subject to” the uncertainty presented by such gain contingency.

XI. LIMITATION OF LIABILITY PROVISIONS IN AUDITOR ENGAGEMENT LETTERS

Faced with the experience of liabilities to third parties resulting from the fraudulent or willful misconduct of their audit clients, or their failure to detect client frauds, auditors are increasingly in their engagement letters seeking to shift responsibility for client misconduct to the client.576 Auditor engagement letters typically describe the objectives of the audit, provide that the information provided to the auditors is the responsibility of management, and set forth the fee arrangements.577 Increasingly auditors are seeking to allocate risks to clients through engagement letter provisions that the client agrees (i) not to hold the auditor liable for damages except those resulting from the auditor’s fraud or willful misconduct (i.e., release the auditor from liability for its own negligence in the conduct of the audit); (ii) the auditor will not be responsible for incidental or consequential damages; (iii) no claim will be asserted against the auditor after a fixed period of time (e.g., two years); (iv) the auditor will be liable only for losses that occur during the period covered by the audit; (v) the client will not assign or transfer any claim against the auditor, including assignments in business combinations or reorganizations; (vi) the client will protect the auditor from third party claims arising from the auditor’s failure to discover negligent conduct by management; and (vii) the auditor’s liability is limited to the amount of fees paid.578

In an Interagency Advisory on the Unsafe and Unsound Use of Limitation of Liability Provisions in External Audit Engagement Letters (the “Advisory”),579 the five federal agencies supervising financial institutions580 expressed the view that limiting an auditor’s liability for an

576 See David Reilly, Generally Accepted Accounting Principle? Auditor Pacts With Companies That Prevent Suits, Limit Awards Draw Scrutiny as Disclosure Grows, WALL ST. J., Mar. 6, 2006, at C1 (noting that public companies are beginning to disclose such engagement letter provisions in their proxy materials); see also Survey Results: Auditor Inspection Reports and Engagement Letters, THE CORPORATE COUNSEL.NET (Jan.–Feb. 2006), http://WWW.THECORPORATECOUNSEL.NET/blog/archive/000927.html, (reporting that a survey of 30 companies showed (i) 63.33% of the companies reported that their most recent auditor engagement letter included a cap on the auditor’s liability (i.e., no liability except for willful misconduct and gross negligence); and (ii) 70% reported that their most recent auditor engagement letter included a provision that waives a jury trial).

577 Interagency Advisory on the Unsafe and Unsound Use of Limitation of Liability Provisions in External Audit Engagement Letters, 71 Fed. Reg. 6,847, 6,849 (Feb. 9, 2006), available at http://a257.g.akamaitech.net/7/257/2422/01jan20061800/edocket.access.gpo.gov/2006/pdf/06-1189.pdf.

578 Id. at 6854–55. 579 Id. at 6847. 580 The Office of Thrift Supervision, Board of Governors of the Federal Reserve System, Federal Deposit


audit may make the auditor less diligent in the audit process and thus make the audit less reliable, which raises safety and soundness concerns. The Advisory excludes (x) limitations on liability for punitive damages and (y) arbitration and other alternative dispute resolution provisions that apply equally to all parties, provide neutral decision makers and appropriate hearing procedures.581 The Advisory warns directors, audit committees and management that “certain insurance policies (such as errors and omissions policies and director and officer liability policies) might not cover losses arising from claims that are precluded by limitation of liability provisions.”582

While the Advisory by its terms applies only to financial institutions (whether public or private), its principles apply to other entities. The SEC has stated that when an auditor and its client enter into an agreement which purports to provide the auditor limitation of liability for its negligent acts, the auditor is not independent:

When an accountant and his client, directly or through an affiliate, have entered into an agreement of indemnity which seeks to assure to the accountant immunity from liability for his own negligent acts, whether of omission or commission, one of the major stimuli to objective and unbiased consideration of the problems encountered in a particular engagement is removed or greatly weakened. Such condition must frequently induce a departure from the standards of objectivity and impartiality which the concept of independence implies. In such difficult matters, for example, as the determination of the scope of audit necessary, existence of such an agreement may easily lead to the use of less extensive or thorough procedures than would otherwise be followed. In other cases it may result in a failure to appraise with professional acumen the information disclosed by the examination. Consequently, the accountant cannot be recognized as independent for the purpose of certifying the financial statements of the corporation.583

Insurance Corporation, National Credit Union Administration and Office of the Comptroller of the Currency. Id. 581 Interagency Advisory on the Unsafe and Unsound Use of Limitation of Liability Provisions in External Audit

Engagement Letters, 71 Fed. Reg. 6,847, 6,853–54 (Feb. 9, 2006), available at http://a257.g.akamaitech.net/7/257/2422/01jan20061800/edocket.access.gpo.gov/2006/pdf/06-1189.pdf.

582 Id. at 6853. 583 Interagency Advisory on the Unsafe and Unsound Use of Limitation of Liability Provisions and Certain

Alternative Dispute Resolution Provisions in External Audit Engagement Letters, 70 Fed. Reg. 24,576, 24,580–81 (May 10, 2005), available at http://www.ots.treas.gov/docs/7/73268.pdf; See SEC Financial Reporting Policies Section 602.02.f.i—Indemnification by Client, 3 Fed. Sec. L. (CCH) ¶ 38,335, at 38,603–17 (2003); see also SEC Office of the Chief Accountant: Application of the Commission’s Rules on Auditor Independence Frequently Asked Questions—Question 4 (issued Dec. 13, 2004):

Q: Has there been any change in the Commission's long standing view (Financial Reporting Policies—Section 600—602.02.f.i. “Indemnification by Client”) that when an accountant enters into an indemnity agreement with the registrant, his or her independence would come into question?

A: No. When an accountant and his or her client, directly or through an affiliate, enter into an agreement of indemnity which seeks to provide the accountant immunity from liability for his or her own negligent acts, whether of omission or commission, the accountant is not independent. Further, including in engagement letters a clause that a registrant would release, indemnify or hold harmless from any liability and costs resulting from knowing misrepresentations by management would also


The PCAOB and the American Institute of Certified Public Accountants (“AICPA”) are reviewing the impact of auditor engagement letter provisions that would reduce auditor liability exposure.584 Currently, Ethics Ruling Number 94 under Rule 101 of AICPA’s Code of Professional Conduct, which is included in the PCAOB’s interim independence standards,585 states that the auditor’s independence is not impaired if the engagement letter includes “a clause that provides that the client would release, indemnify, defend, and hold the member . . . harmless from any liability and costs resulting from knowing misrepresentations by management.”586 Since auditors must comply with the SEC’s auditor independence requirements set forth above (as well as those of the PCAOB) in a public company audit, AICPA Ethics Ruling Number 94 has no practical effect with respect to audits of public companies. Additionally, Ethics Ruling Number 95 under Rule 101 of the AICPA Code of Professional Conduct, which is also included in the PCAOB’s interim independence standards, currently states that independence would not be impaired if the auditor and the audit client agreed to alternative dispute resolution (“ADR”) to resolve disputes relating to past services.587 The AICPA is proposing to amend its independence standards to parallel the position of the Advisory so that generally limitation of auditor liability provisions in engagement letters would prejudice independence, but punitive damage limitation, ADR and the unsuccessful party to a lawsuit or ADR pays the costs of the successful party provisions would not impair auditor independence.588

impair the firm's independence.

Interagency Advisory on the Unsafe and Unsound Use of Limitation of Liability Provisions and Certain Alternative Dispute Resolution Provisions in External Audit Engagement Letters, 70 Fed. Reg. at 24,581.

584 See Agenda for PCAOB Standing Advisory Group Meeting on February 9, 2006 under “Emerging Issue—The Effects on Independence of Indemnification, Limitation of Liability, and Other Litigation-Related Clauses in Audit Engagement Letters,” available at http://www.pcaobus.org/News_and_Events/Events/2006/02-09.aspx, and related Standing Advisory Group white paper dated February 9, 2006 and entitled "Emerging Issue—The Effects on Independence of Indemnification, Limitation of Liability, and Other Litigation-Related Clauses in Audit Engagement Letters", available at http://www.pcaobus.org/Standards/Standing_Advisory_Group/Meetings/2006/02-09/Indemnification.pdf; AICPA Proposed Interpretation 101-16 (Sept. 15, 2005), available at http://www.aicpa.org/download/ethics/2--5_0915_ed_Indemn.pdf, which sets forth the AICPA’s position on the types of clauses discussed above.

585 The PCAOB adopted as its interim independence standards (see PCAOB Rule 3600T) the AICPA Code of Professional Conduct Rules 101 and 191, and related interpretations and rulings, as they existed on April 16, 2003, to the extent not superseded or amended by the PCAOB. See PCAOB R. 3600T.

586 AICPA Code of Professional Conduct, ET § 191-94, Ethics Rulings on Independence, Integrity, and Objectivity, “Ethics Ruling No. 94, Indemnification Clause in Engagement Letters” (Am. Inst. of Certified Pub. Accountants), available at http://www.aicpa.org/about/code/et_191.html#N94._indemnification_clause_in_engageme nt_letters.

587 AICPA Code of Professional Conduct, ET § 191-95, Ethics Rulings on Independence, Integrity, and Objectivity, “Ethics Ruling No. 95, Agreement With Attest Client to Use ADR Techniques” (Am. Inst. of Certified Pub. Accountants), available at http://www.aicpa.org/about/code/et_191.html#N95._agreement_with_attest_client_to_ use_adr_techniques.

588 See AICPA Proposed Interpretation 101-16, Indemnification, Limitation of Liability, and ADR Clauses in Engagement Letters (Sept. 15, 2005) available at http://www.aicpa.org/download/ethics/2--5_0915_ed_Indemn.pdf (setting forth the AICPA’s proposed position on the types of clauses discussed above).


XII. EFFECT OF SOX ON FOREIGN COMPANIES

A. Which Foreign Companies Are Subject to SOX?

The provisions of SOX apply to public companies even if domiciled outside of the United States.589 Many of the SEC rules promulgated under SOX’s directives provide limited relief from some SOX provisions for the “foreign private issuer,” which the SEC defines as a private corporation or other organization incorporated outside of the United States, as long as:

(1) More than 50% of the issuer’s outstanding voting securities are not directly or indirectly held of record by U.S. residents; and

(2) Any one of the following:

(i) the majority of the executive officers or directors are not U.S. citizens or residents;

(ii) more than 50% of the issuer’s assets are not located in the United States; or

(iii) the issuer’s business is not administered principally in the United States.590

A foreign private issuer may use Form 20-F both to register a class of its securities under the 1933 Act and as its SEC annual report under the 1934 Act, due within six months after the end of each fiscal year.591 A number of the SOX provisions have exceptions applicable to foreign private issuers as discussed below.

B. What Differences Are There in the Application of SOX Provisions to Foreign Private Issuers?

1. Public Company Accounting Oversight Board

The Title I rules apply to foreign accounting firms that audit foreign corporations which are reporting companies under the 1934 Act or that are offering securities in a registered public offering under the 1933 Act.592 The PCAOB may also determine by rule that a foreign public accounting firm that does not prepare or issue the audit report of such a foreign company, but that nonetheless plays such a substantial role in preparing or issuing its audit report, should be treated as a public accounting firm under SOX.593

589 See supra note 2 and related text. 590 17 C.F.R. § 240.3b-4(c) (2008). 591 17 C.F.R. § 249.220f (2008). 592 See supra notes 26–30 and related text. 593 SOX §106(a)(1), 15 U.S.C.A. § 7216(a)(1) (West Supp. 2007) [hereinafter SOX § 106].


2. Auditor Independence; Non-Audit Services

All of the Title II rules apply equally to foreign private issuers.594 A foreign private issuer is required to disclose in its Form 20-F or 40-F the fees paid to its auditors for (1) audit services; (2) audit-related services; (3) tax services; and (4) other services.595

C. Corporate Responsibility

1. Audit Committee Independence Rules

The SOX § 301 rule applies to foreign private issuers.596 Because the requirements for a U.S.-style audit committee may conflict with legal requirements, corporate governance standards, and the methods for providing auditor oversight in the home jurisdictions of some foreign private issuers, the SEC has provided some exceptions to the audit committee independence rules.597 These exceptions provided by the SOX § 301 Release are summarized below.

a. Allowing Non-Management Employee to Serve

Non-management employees will be allowed to serve on the audit committee of a foreign private issuer if the employee is elected or named to the board of directors or audit committee of the foreign private issuer pursuant to home country legal or listing requirements.598

b. Allowing Controlling Shareholder to Serve

In foreign jurisdictions providing for audit committees, representation of controlling shareholders is common. The SEC suggests that in the case of foreign private issuers, one member of the audit committee could be a shareholder, or representative of a shareholder or group, owning more than 50% of the voting securities of the foreign private issuer, if the “no compensation” prong of the independence requirement is satisfied, the member in question has only observer status on, and is not a voting member or the chair of, and the member in question is not an executive officer of the issuer.599

c. Allowing Government Representative to Serve

To accommodate foreign practices, one member of the audit committee of a foreign private issuer could be a representative of a foreign government or foreign governmental

594 Title II Release, supra note 31 at 6006. 595 Id. at 6024. 596 SOX § 301 Release, supra note 106 at 18,790. 597 For example, in some countries: (i) the auditors report to shareholders at the annual meeting and are

responsible to them; (ii) there are no requirements to have an audit committee; (iii) if there is a requirement for an audit committee, there is no requirement its members are independent; and (iv) there are two tiers of board membership: a lower tier of employee members, either management or non-management, and an upper-tier of supervisory members.

598 SOX § 301 Release, supra note 106 at 18,802. 599 Id. at 18,802–03.


entity, as long as “the ‘no compensation’ prong of the independence requirement[] is [satisfied] and the member in question is not an executive officer of the issuer.”600

d. No Independent Audit Committee Required if Board of Auditors

Foreign private issuers’ boards of auditors or similar bodies of statutory auditors, which operate under legal or listing provisions and are intended to provide oversight of outside auditors that are independent of management are exempted from the more demanding independence requirements in the SOX § 301 Release, as long as membership on such a board excludes executive officers of the foreign private issuer and such board or body is (to the extent permitted by the law of its home jurisdiction) responsible for the appointment and retention of any registered public accounting firm engaged by the listed issuer.601

e. Audit Committee Financial Experts

A foreign private issuer must disclose whether it has an audit committee financial expert who is independent, as that term is defined by the applicable listing standards for the issuer’s exchange.602 If a foreign company is not a listed issuer, it must choose one of the definitions of audit committee member independence used by a major stock exchange for purposes of determining whether its financial expert is independent.603

A foreign private issuer availing itself of any of the exemptions described above must disclose in, or incorporate by reference into, its annual report on Form 20-F or 40-F its: (a) reliance on the exemption and (b) assessment of whether (and if so, how) such reliance would materially adversely affect the ability of their audit committee to act independently and to satisfy the other requirements of the proposed rules.604

In the case of a foreign private issuer with a two-tier board of directors, the term “board of directors” means the supervisory or non-management board.605 That board may either form an audit committee that complies with the independence requirements, or if the entire board is independent, it may be designated as the audit committee. To the extent an audit committee is required to conduct oversight duties, establish procedures to receive complaints, have authority to hire independent counsel, identify and disclose the “financial expert” if there is one (and if not, why not), and if the foreign private issuer is not required to have an audit committee under one of the exemptions to the Title III Rules provided above (e.g., either because it has a two-tier board structure and the upper tier is independent, or because it has a board of auditors), then the board members represented by the alternatively allowed structure shall perform the duties of an audit committee.606

600 Id. at 18,803. 601 Id. 602 Id. at 18,808. 603 Id. at 18,808–09. 604 Id. at 18,820. 605 Id. at 18,817. 606 Id. at 18,809.


2. CEO/CFO Certifications under §§ 302 and 906

Calendar year foreign private issuers must include certifications in their annual Forms 20-F and 40-F.607 Since foreign private issuers make no quarterly filings but report updated information from time to time during the year on Form 6-K, no quarterly certification would be required (Form 6-K, like Form 8-K, is not considered “filed” with the SEC).608

3. Misleading Statements to Auditors

Foreign companies are equally subject to SOX § 303 and expanded Rule 13b2-2. “In applying the rule to foreign private issuers, the terms ‘officer’ and ‘director’ would indicate those performing equivalent functions under the local laws and corporate governance practices where the issuer is domiciled.”609 “In addition, the term ‘independent public or certified public accountant’ includes accountants in foreign countries who engage in auditing or reviewing an issuer’s financial statements or issuing attestation reports to be filed with the [SEC], regardless of the title or designation used in those countries.”610

4. CEO/CFO Reimbursement

SOX § 304 applies equally to foreign companies, with the same July 30, 2002, effective date, although, as in the case of U.S. issuers, it is unclear how § 304 will be enforced in practice.611

5. Insider Trading Freeze During Plan Blackout

Regulation BTR limits SOX § 306(a)’s application to the directors and executive officers of a foreign private issuer612 to situations where (i) 50% or more of the participants or beneficiaries located in the United States in individual account plans maintained by the issuer are subject to a temporary trading suspension in issuer equity securities, (ii) the affected participants and beneficiaries represent an appreciable portion of the issuer’s worldwide employees, and (iii) the issuer is considered to have a sufficient presence for purposes of applying the SOX § 306(a) trading prohibition to its directors and executive officers.613 A foreign private issuer will have sufficient presence for the trading prohibition if:

• the number of participants and beneficiaries located in the United States in individual account plans maintained by . . . [the] issuer who are subject to a

607 Certification of Disclosure in Companies’ Quarterly and Annual Reports, Exchange Act Release No. 46,079,

67 Fed. Reg. 41,877, 41,882 (June 20, 2002), available at http://www.sec.gov/rules/proposed/34-46079.htm. 608 See id. 609 Exchange Act Release No. 47,890, supra note 414 at 31,821 n.12. 610 Id. at 31,825 n.67. 611 SOX § 304, supra note 167. 612 For a foreign private issuer, a “director” is a director who is a management employee of the issuer, and an

“executive officer” is the principal executive officer or officers, a principal financial officer or officers, and the principal accounting officer or officers. 17 C.F.R. § 245.100 (2008).

613 Exchange Act Release No. 47,225, supra note 176, at 4339.


temporary trading suspension in issuer equity securities exceeds 15% of the number of employees of the issuer worldwide . . .[; or]

• the number of participants and beneficiaries located in the United States in individual account plans maintained by . . . [the] issuer who are subject to a temporary trading suspension in issuer equity securities does not exceed 15% of the number of employees of the issuer worldwide but exceeds 50,000 participants and beneficiaries.614

Likewise, as noted in Exchange Act Release No. 47,225:

If the number of participants and beneficiaries located in the United States in individual account plans maintained by the issuer who are subject to a temporary trading suspension in issuer equity securities does not exceed 15% of the issuer’s employees worldwide and involves 50,000 or fewer participants and beneficiaries, the issuer’s presence in the United States will be considered sufficiently small so that its directors and executive officers will not be subject to the SOX § 306(a) trading prohibition.615

6. Enhanced Attorney Responsibilities

The SOX § 307 Rules apply to all attorneys, whether in-house counsel, outside counsel, or those in foreign jurisdictions, “appearing and practicing” before the SEC.616 The term “appearing and practicing” before the SEC is defined to include, without limitation:

([1]) [t]ransacting any business with the [SEC], including communication in any form [with the SEC]; ([2]) [r]epresenting an issuer in a[n SEC] administrative proceeding or in connection with any [SEC] investigation, inquiry, information request, or subpoena; ([3]) [p]roviding advice in respect of the [U.S.] securities laws . . . regarding any document that the attorney has notice will be filed with[,] or submitted to, or incorporated into any document that will be filed with or submitted to, the [SEC], including the provision of such advice in the context of preparing, or participating in the preparation of, any such document; or ([4]) [a]dvising an issuer as to whether information or a statement, opinion, or other writing is required under the [U.S.] securities laws . . . to be filed with or submitted to, or incorporated into any document that will be filed with or submitted to . . . the [SEC]; but . . . [d]oes not include an attorney who: (i) conducts the[se] activities . . . other than in the context of providing legal services to an issuer with whom the attorney has an attorney-client relationship; or (ii) [i]s a non-appearing foreign attorney.617

614 Id. at 4346. 615 Id. 616 17 C.F.R. § 205.1 (2008). 617 17 C.F.R. § 205.2 (2008).


In recognition of the difficulties encountered by “foreign lawyers and international law firms because applicable foreign standards might be incompatible with the [attorney conduct] rule[s],”618 the SOX § 307 Rules exempt “non-appearing foreign attorneys” who:

• [A]re admitted to practice law in a jurisdiction outside the United States; . . .

• [D]o not hold themselves out as practicing, [and do not] giv[e] legal advice regarding, [U.S. federal or state securities or other] law[s]; and [either] . . .

o [C]onduct activities that would constitute appearing and practicing before the [SEC] only . . . incidentally to[, and in the ordinary course of, the] practice [of law in a jurisdiction outside the United States;] or . . .

o [Appear and practice before the SEC only] in consultation with . . . counsel[, other than a non-appearing foreign attorney, admitted or licensed to practice in a state or other U.S. jurisdiction].619

Thus, foreign attorneys who provide legal advice regarding U.S. securities law, other than in consultation with U.S. counsel, are subject to the SOX § 307 Rules if they conduct activities that constitute appearing and practicing before the SEC.620 The SOX § 307 Rules cite as an “example, an attorney licensed in Canada who independently advises an issuer regarding the application of [SEC] regulations to a periodic filing with the [SEC]. . . . [A lawyer in those circumstances would be subject to the SOX § 307 Rules].”621

In addition, the SEC adopted Paragraph 205.6(d) of the SOX § 307 Rules. This was done “to protect lawyer’s practicing outside the United States in circumstances where foreign law prohibits compliance with the [SOX § 307 Rules]”:622

(d) An attorney practicing outside the United States shall not be required to comply with the requirements of this part to the extent that such compliance is prohibited

618 SOX § 307 Release, supra note 459, at 6303–04. In the SOX § 307 Release, the SEC commented:

The Commission respects the views of the many commenters who expressed concerns about the extraterritorial effects of a rule regulating the conduct of attorneys licensed in foreign jurisdictions. The Commission considers it appropriate, however, to prescribe standards of conduct for an attorney who, although licensed to practice law in a foreign jurisdiction, appears and practices on behalf of his clients before the Commission in a manner that goes beyond the activities permitted to a non-appearing foreign attorney. Non-United States attorneys who believe that the requirements of the rule conflict with law or professional standards in their home jurisdiction may avoid being subject to the rule by consulting with United States counsel whenever they engage in any activity that constitutes appearing and practicing before the Commission.

Id. at 6304. 619 Id. at 6303. 620 Id. See also 17 C.F.R. § 205.1 (2008). 621 SOX § 307 Release, supra note 459, at 6303. 622 Id. at 6304.


by applicable foreign law.623

Where the foreign attorney rules are not prescribed by statute, but by bar association or court rules, the Paragraph 205.6(d) exception may not be available.624 In any event, the SEC would require the foreign lawyer to comply with the SOX § 307 Rules to the furthest extent not prohibited by applicable foreign law.625

Further, U.S. attorneys who work for foreign private issuers would be subject to the SOX § 307 Rules626 and applicable state bar disciplinary rules in respect to their service for foreign private issuers. They could be held responsible under SEC Rule 13b2-2 under the 1934 Act for improperly influencing the auditor of a foreign private issuer’s financial statements filed with the SEC.627

D. Enhanced Financial Disclosures; Prohibition on Insider Loans

1. Off-Balance Sheet Transactions; Use of Non-GAAP Financial Measures

Forms 20-F and 40-F have been amended. They now require foreign private issuers to make the same disclosures required of domestic companies in respect to off-balance sheet items in their filings made for fiscal years ending on or after June 15, 2003.628 The table of

623 17 C.F.R. § 205.6(d) (2008). 624 SOX § 307 Release, supra note 459, at 6314 (noting “paragraph 205.6(d) addresses the conduct of non-U.S.

attorneys who are subject to this part”) (emphasis added). 625 17 C.F.R.§ 205.6(d) (2008). 626 In advising foreign private issuers with respect to U.S. securities law matters, U.S. counsel may encounter

situations where, in their judgment, the U.S. securities laws and SOX § 307 Rules require them to take actions which would not be required under the laws of the jurisdiction in which the issuer is organized or principally conducts its business. See Patrick McGeehan, Lawyers Take Suspicions On TV Azteca To Its Board, N.Y. TIMES, Dec. 24, 2003, at C1:

In one of the first applications of a new provision of the Sarbanes-Oxley Act, outside lawyers for Mexico’s second-largest broadcaster have told its board—and, possibly, federal regulators—that they think that the company violated United States securities laws.

The company, TV Azteca, has had a long-running dispute with lawyers in New York about the need for greater disclosure about transactions that could have yielded a profit of more than $100 million to the company’s billionaire chairman and controlling shareholder, Ricardo B. Salinas Pliego. When company executives refused to make the disclosures that the lawyers demanded, the lawyers cited the new provision of the act, which requires them to notify the company’s board and permits them to contact regulators as well. . . .

[I]n a Dec. 12 letter to the boards of TV Azteca and its parent company, Azteca Holdings, [outside New York counsel citing SOX § 307] told the boards that [the firm] was withdrawing as counsel to the company on a pending bond offering and that it might notify the Securities and Exchange Commission of its withdrawal and the reasons for it.

The SEC filed civil fraud charges against TV Azteca, its parent company, and three of its officers and directors on Jan. 4, 2005 alleging significant related party transactions which were undisclosed in TV Azteca’s periodic reports. See TV Azteca, 84 SEC Docket 52,283 (Jan. 4, 2005). In the SEC Litigation Release, the SEC noted that the company’s outside counsel withdrew from its representation pursuant to its duties under § 307 of SOX. Id.

627 See supra notes 414–21 and related text. 628 Securities Act Release No. 8182, supra note 232, at 5991.


contractual obligations is required in filings made for fiscal years ending on or after December 15, 2003.629

With respect to the preparation of their primary financial statements, the SEC did not impose U.S. GAAP on foreign private issuers.630 Thus, for a foreign private issuer that discloses a non-GAAP financial measure derived from a measure calculated in accordance with its home country or local GAAP, “GAAP” will refer to its home country’s GAAP.631 For purposes of applying Regulation G to the disclosure of that measure, those that disclose a non-GAAP financial measure derived in accordance with U.S. GAAP, “GAAP” refers to U.S. GAAP.632 However, prior to SOX, foreign private issuers whose primary financial statements were prepared in accordance with a non-U.S. GAAP, were required to include in their management discussion and analysis (“MD&A”) a discussion of the reconciliation to U.S. GAAP and any differences between foreign and U.S. GAAP. This is only if it would be necessary for an understanding of the financial statements as a whole.633 Consistent with that pre-SOX MD&A requirement for foreign private issuers, the disclosure of off-balance sheet arrangements and the table of contractual obligations, should focus on the primary financial statements presented in the document, while taking the reconciliation into account.634

In Response, the SEC has published, for public comment, a proposal that would allow foreign private issuers to file their financial statements without reconciliation to U.S. GAAP. The relief would only be available to foreign private issuers that file their financial statements in full compliance with the English language version of International Financial Reporting Standards (“IFRS”), as published by the International Accounting Standards Board (“IASB”).635 Foreign private issuers would be required to state, in a prominent footnote in their financial statements, that such financial statements are in compliance with IFRS as published by IASB. Furthermore, the issuer’s independent auditor must render an opinion stating the issuer’s financial statements comply with IFRS (as published by the IASB).

2. Conditions for Use of Non-GAAP Financial Measures: Regulation G

Regulation G applies to any disclosures made in a Form 20-F filed with respect to a fiscal period ending after March 28, 2003, unless:

• “the securities of the foreign company are listed or quoted on a securities exchange or inter-dealer quotation system outside the United States;

629 Id. at 5992. 630 Securities Act Release No. 8176, supra note 244. 631 Id. 632 Id. 633 Securities Act Release No. 8182, supra note 232, at 5992. 634 Id. 635 Press Release, SEC Soliciting Public Comment on Eliminating Reconciliation Requirement for IFRS

Financial Statements, (July 3, 2007), available at http://www.sec.gov/news/press/2007/2007-128.htm; see Press Release, SEC Soliciting Public Comment on Role of IFRS in the U.S., (July 25, 2007), available at http://www.sec.gov/news/press/2007/2007-145.htm.


• the non-GAAP financial measure is not derived from, or based on a measure calculated and presented in accordance with generally accepted accounting principles in the United States; and

• the disclosure is made by or on behalf of the foreign private issuer outside the United States or is included in a written communication that is released by or on behalf of the foreign private issuer outside the United States.”636

These exceptions apply even if one or more of the following circumstances exists:

• “a written communication is released in the United States as well as outside the United States, so long as the communication is released in the United States contemporaneously with, or after the release outside the United States and is not otherwise targeted at persons . . . in the United States;

• foreign journalists, U.S. journalists or other third parties have access to the information;

• the information appears on one or more websites maintained by the [foreign private issuer], so long as the websites, taken together, are not available exclusively to, or targeted at, persons located in the United States; or

• following the disclosure or release of information outside of the United States, the information is included in a submission to the [SEC in] a Form 6-K.”637

There is no such exemption from Regulation G for disclosure of non-GAAP financial measures in Form 20-F. However, an otherwise impermissible non-GAAP financial measure will be allowed if it is affirmatively permitted (more than just not disallowed) by the standard-setter for GAAP used in the foreign private issuer’s primary financial statements. It is also included in the foreign private issuer’s annual report of financial statements used in its home jurisdiction.638 Certain Canadian issuers who file annual reports with the SEC on Form 40-F,

636 Securities Act Release No. 8176, supra note 244, at 4821. 637 Id. 638 Frequently Asked Questions Regarding the Use of Non-GAAP Financial Measures (June 13, 2003), available

at http://www.sec.gov/divisions/corpfin/faqs/nongaapfaq.htm. The staff discussed:

[t]he [n]ote to Item 10(e) of Regulation S-K [that] permits a foreign private issuer to include in its filings a non-GAAP financial measure that otherwise would be prohibited . . . if, among other things, the non-GAAP financial measure is required or expressly permitted by the standard setter that is responsible for establishing the GAAP used in the company’s primary financial statements included in its filing with the [SEC].

Id. In response to the question of what “expressly permitted” means, the staff advised that a measure would be considered “expressly permitted” if the particular measure “is clearly and specifically identified as an acceptable measure by the standard setter that is responsible for establishing the GAAP used in the company’s primary financial statements included in its filing with the Commission.” Id. For example:


under the Multi-Jurisdictional Disclosure System (the “MJDS”), are not subject to reconciliation of non-GAAP measures used in Form 40-F. This is because the Canadian disclosure form dictates what must be disclosed in filings made with the SEC under the MJDS. However, those Canadian issuers are subject to Regulation G with respect to any public disclosures made in the United States that contain non-GAAP financial measures.639

3. Internal Controls

While SOX § 404(a) rules require management to base its assessment of the effectiveness of the issuer’s ICFR on a suitable, and recognized control framework (established by a group that has followed due process procedures, including the evaluative framework set forth in the COSO Report), foreign private issuers are permitted to use the framework in effect in their home jurisdictions for this purpose.640 The dates by which foreign private issuers must comply with SOX § 404 are as follows:641

[s]ome non-U.S. GAAP standard setters specify a minimum level of caption detail for financial statement presentation . . . but require or permit additional caption detail . . . , [and sometimes] the standard setter does not specify the particular additional captions to be presented. The staff [stated] that [the] additional detail of the components of the financial statements determined in conformity with the GAAP used in the primary financial statements will generally be useful to [U.S.] investors . . . [and t]he “expressly permitted” condition is not intended to prohibit the inclusion of those captions. [Likewise, s]ome non-U.S. GAAP standard setters permit or require subtotals in financial statements that are not calculated consistently with those permitted or required by U.S. GAAP . . . [, and p]rovided that the subtotal is clearly derived from the appropriately classified financial statement captions that precede it, [the staff advised that] the “expressly permitted” condition [was] not intended to prohibit . . . inclusion of those [subtotals].

Id. 639 N. Adele Hogan, Non-GAAP Financial Measures & “Real-Time” Reporting: Final Rules Pursuant to

Sections 401(b) & 409 of the Sarbanes-Oxley Act, in UNDERSTANDING THE SECURITIES LAWS, 93 (Practicing Law Institute 2003).

640 Securities Act Release No. 8238, supra note 154, at 36,642. 641 Internal Control Over Financial Reporting In Exchange Act Periodic Reports of Foreign Private Issuers That

Are Accelerated Filers, Securities Act Release No. 8730A, Exchange Act Release 54,294A (Aug. 9, 2006), available at http://www.imanet.org/pdf/404F.pdf.


Issuer Status

Management Assessment of

ICFR—Fiscal Year Ending

Auditor’s Attestation Report—Fiscal Year

Ending Large Accelerated Filer642 July 15, 2006 July 15, 2006 Accelerated Filer643 July 15, 2006 July 15, 2007 Non-accelerated Filer644 December 15, 2007 December 15, 2008

4. Prohibition on Loans to Directors and Officers

SOX § 402 applies equally to foreign companies, with the same July 30, 2002, effective date. However, the exception for loans by banks with deposits insured by the Federal Deposit Insurance Corporation (“FDIC”), disadvantages foreign banks whose deposits generally cannot be FDIC-insured even though they might be subject to insider lending restrictions similar to those applicable to FDIC-insured institutions. Under some foreign banking regulations, bank directors and executive officers are further prohibited from borrowing money from other banks and financial institutions.645 Furthermore, as discussed in Exchange Act Release No 48,481:

[A]lthough not required by local regulations, some foreign banks, like some of their U.S. counterparts, have implemented policies that prohibit senior insiders from borrowing money from other banks for the purpose of enhancing oversight and surveillance of financial transactions by insiders. The combination of these prohibitions and the provisions of [SOX §] 402 would . . . effectively foreclose a director or executive officer of a foreign bank whose securities are registered with the [SEC] from borrowing money.646

To level the playing field, the SEC has adopted 1934 Act Rule 13k-1 that exempts from the SOX § 402 insider lending prohibition an issuer that is a foreign bank647 or the parent

642 Exchange Act Rule 12b-2(2), 17 C.F.R. 240.12b-2(2), defines a large accelerated filer as an issuer that,

among other criteria, has an aggregate market value of voting and non-voting common equity held by non-affiliates of the issuer of $700 million or more as of the last day of the issuer’s most recently completed second fiscal quarter. 17 C.F.R. 240.12b-2(2) (2008).

643 Exchange Act Rule 12b-2(1), 17 C.F.R. 240.12b-2(1), defines an accelerated filer as an issuer that, among other criteria, has an aggregate market value of voting and non-voting common equity held by non-affiliates of the issuer of $75 million or more as of the last day of the issuer’s most recently completed second fiscal quarter and is not a “large accelerated filer.” 17 C.F.R. 240.12b-2(1) (2008).

644 The term “non-accelerated filer” is not defined in the SEC rules, but is used by the SEC to refer to an Exchange Act reporting company that does not meet the Exchange Act Rule 12b-2 definition of either an “accelerated filer” or a “large accelerated filer.” Internal Control Over Financial Reporting In Exchange Act Periodic Reports of Foreign Private Issuers That Are Accelerated Filers, Securities Act Release No. 8730A, Exchange Act Release 54,294A, at n.5 (Aug. 9, 2006), available at http://www.sec.gov/rules/final/finalarchive/finalarchive2006.shtml.

645 Foreign Bank Exemption From the Insider Lending Prohibition of Exchange Act Section 13(k), Exchange Act Release No. 48,481, 68 Fed. Reg. 54,590, 54,591 (Sept. 17, 2003), available at http://www.sec.gov/rules/proposed/34-48481.htm.

646 Id. 647 See SOX § 401, supra note 229. Rule 13k-1:


company of a foreign bank with respect to loans by the foreign bank to its insiders or the insiders of its parent company as long as:

(1) Either:

(i) [t]he laws or regulations of the foreign bank’s home jurisdiction require the bank to insure its deposits or be subject to a deposit guarantee or protection scheme; or

(ii) [t]he Board of Governors of the [U.S.] Federal Reserve System has determined that the foreign bank or another bank organized in the foreign bank’s home jurisdiction is subject to comprehensive supervision or regulation on a consolidated basis by the bank supervisor in its home jurisdiction under 12 CFR 211.24(c); and

(2) The loan by the foreign bank to any of its directors or executive officers or those of its parent or other affiliate:

(i) [i]s on substantially the same terms as those prevailing at the time for comparable transactions by the foreign bank with other persons who are not executive officers, directors or employees of the foreign bank, its parent or other affiliate; or

(ii) [i]s pursuant to a benefit or compensation program that is widely available to the employees of the foreign bank, its parent or other affiliate and does not give preference to any of the executive officers or directors of the foreign bank or its parent company over any other employees of the foreign bank, its parent or other affiliate over any other employees of the foreign bank, its parent or other affiliate; or

(iii) [h]as received express approval by the bank’s supervisor in the foreign bank’s home jurisdiction.648

employ[s] a definition of “foreign bank” that is similar to the definition under Regulation K of the [Federal Reserve] Board. . . . Under [the Rule 13k-1] definition, a foreign bank is an institution that is: “(1) incorporated or organized under the laws of a country other than the United States or a political subdivision of a country other than the United States; (2) regulated as a bank by that country’s or subdivision’s government; and (3) engaged [directly] in the business of banking.

This definition . . . also include[s] a provision explaining that, in order to be an institution engaged [directly] in the business of banking, a foreign entity must [engage directly in banking activities that are usual for the business of banking in its home jurisdiction].

Foreign Bank Exemption From the Insider Lending Prohibition of Exchange Act Section 13(k), 68 Fed. Reg. at 54,591–92.

648 Foreign Bank Exemption from the Insider Lending Prohibition of Exchange Act Section 13(k), Exchange Act Release 49,616, 82 SEC Docket 2538 (Apr. 26, 2004), available at http://www.sec.gov/rules/final/34-49616.htm.


5. Accelerated § 16(a) Reporting

Rule 3(a)12-3 under the 1934 Act provides that securities registered by a foreign private issuer are exempt from § 16.649

6. Code of Ethics

A foreign private issuer is required to make disclosure regarding its Code of Ethics on Forms 20-F and 40-F filed for fiscal years ending on or after July 15, 2003.650 Disclosure of waivers that have occurred during the past fiscal year must be made in the annual report, although the SEC encourages disclosure to be made more promptly on Form 6-K or on the company’s website.651

7. Systematic Review of 1934 Act Filings

Like U.S. issuers, foreign private issuers can expect to have their annual reports reviewed by the SEC at least once every three years.652

8. Accelerated Disclosure in Plain English

Foreign private issuers filing annual reports on Form 20-F or 40-F are not required to make “real time” disclosure in plain English.653 To the extent that a foreign private issuer has as class of its securities listed on a national securities exchange or NASDAQ, it may be required to make disclosures of material nonpublic information under such SRO’s standards for continued listing.654

9. Accelerated Filing Deadlines

Foreign filers are not subject to the accelerated filing deadlines of 10-Ks and 10-Qs, but the SEC has indicated it is continuing to consider changes to the Form 20-F filing deadlines.655

10. Enhanced MD&A Disclosure

Foreign private issuers are subject to the same required enhanced MD&A disclosure

649 17 C.F.R. § 240.3a12-3 (2008). 650 SOX §§ 406/407 Release, supra note 352. 651 Id. at 5120–21. 652 SOX § 408, supra note 386. 653 Additional Form 8-K Disclosure Requirements and Acceleration of Filing Date, Securities Act Release No.

8400, Exchange Act Release No. 49,424, 69 Fed. Reg. 15,594 (Mar. 25, 2004), available at http://www.sec.gov/rules/final/33-8400.htm.

654 Selective Disclosure and Insider Trading, Securities Act Release No. 7881, Exchange Act Release No. 43,154, Investment Company Act Release No. 24,599, 65 Fed. Reg. 51,716, 51,724-25 (Aug. 24, 2000), available at http://www.sec.gov/rules/final/33-7881.htm; see also Michael Gruson, Global Shares of German Corporations and Their Dual Listings on the Frankfurt and New York Stock Exchanges, 22 U. PA. J. INT’L ECON. L. 185, 189 n.7 (2001).

655 Securities Act Release No. 8128, supra note 389, at 58,488.


requirements as U.S. issuers.656 However, foreign private issuers are not required to file “quarterly” reports with the SEC. Thus, unless a foreign private issuer files a 1933 registration statement that must include interim period financial statements and related MD&A disclosure, it will not be required to update its MD&A disclosure more frequently than annually.

11. Termination of SEC Filing Obligations

On March 27, 2007, the SEC amended its rules to make it easier for foreign private issuers to deregister and terminate their SEC reporting obligations in the United States.657 A foreign private issuer of equity securities will be “permit[ted] . . . to terminate its reporting obligations under [1934 Act §§] 13(a) or . . . 15(d) . . . by meeting a quantitative benchmark designed to measure relative United States market interest for its equity securities. . . . [It] does not depend on a head count of the issuer’s United States security holders[, as under the previous rules, and using a 5 percent benchmark,] will permit a foreign private issuer[, regardless of size,] to compare the average daily trading volume of its securities in the [United States with its worldwide average daily trading volume.”658 The determination of the denominator when measuring against this 5 percent threshold is based on worldwide trading volume, rather than trading volume in the issuer’s one or two primary markets.659 Off-market trading will be counted worldwide, and not only in the United States, so long as the information source is reliable and not duplicative of exchange-reported trading.660 Convertible and other equity-linked securities are also not counted in the threshold calculation.661 Issuers terminating their listings or ADR programs must have satisfied the trading volume standard as of the date of delisting, as measured over the 12 months immediately preceding the date of delisting.662

XIII. EFFECT OF SOX ON PRIVATE COMPANIES AND BUSINESS COMBINATIONS

The impact of SOX is beginning to extend beyond the companies to which it is literally applicable, to now encompass private companies in which the owner’s exit strategy may be sale to a public company or a public offering.663 Those entities providing or arranging financing for public companies, or private companies whose exit strategy includes a public offering or being acquired by a public company, also will need to consider how the SOX requirements may affect the companies with which they deal.

656 Securities Act Release No. 8182, supra note 232, at 5991. 657 See generally Termination of a Foreign Private Issuer's Registration of a Class of Securities Under Section

12(g) and Duty to File Reports Under Section 13(a) or 15(d) of the Securities Exchange Act of 1934, Exchange Act Release No. 55,540, 72 Fed. Reg. 16,934 (Mar. 27, 2007), available at http://www.sec.gov/rules/final/2007/34-55540.pdf.

658 Id. at 16,934. 659 Id. 660 Id. 661 Id. 662 Id. 663 See generally American Institute of Certified Public Accountants (AICPA), The State Cascade—An Overview

of the State Issues Related to the Sarbanes-Oxley Act, http://www.aicpa.org/statelegis/index.asp (last visited Nov. 13, 2004).


SOX will be applicable to the buyer if it will be a public company after the transaction. Even through a class of high yield debt which may have been privately placed in an SEC Rule 144A transaction with a covenant to exchange the privately placed debt for SEC registered debt, or to become and remain subject to the SEC reporting requirements.664 Further, if the seller is a public company going private, SOX problems present while the company was public will follow the company’s reputation into its private company life.

In the case of a private company being acquired, the acquiring public company will have to certify in its SEC reports as to its consolidated financial statements in its first periodic report after the combination. This puts the buyer’s CEO and CFO in the position of having to certify the financial statements and internal controls of the consolidated entity, including the acquired company.665 Those certifications in turn will require the buyer to be sure of the seller’s SOX conformity before the transaction is contemplated so that there will not be a post closing financial reporting surprise.

The foregoing results in increased emphasis on due diligence. This emphasis manifests itself through expanded representations and warranties in acquisition agreements and financing agreements, as well as through hiring auditors to review the work papers of the seller’s auditors.666 The target’s auditors typically resist opening up their work papers, but ultimately may accede in exchange for a letter to the effect that the buyer acknowledges that the work papers are useless and will not be relying on them.667 Sometimes the auditors ask for (but do not receive) an indemnification in exchange for access to the work papers.

Set forth below are sample representations as to financial statements, internal controls, SEC reports, CEO and CFO certifications, loans to directors and officers, and compliance with laws that have been modified to address SOX concerns and sample covenants dealing with certain SOX issues (provisions that are particularly relevant post-SOX are bold faced):668

Financial Statements. The financial statements of the Company and its subsidiaries included in the Company SEC Documents (including the related notes) complied as to form, as of their respective dates of filing with the SEC, in all material respects with applicable accounting requirements and the published rules and regulations of the SEC with respect thereto (including, without limitation, Regulation S-X, have been prepared in accordance with generally accepted accounting principles in the

664 Gerald T. Nowak, Andrew J. Terry & William Chou, In the Twilight Zone: The Unique Status of High Yield-

Only Issuers, 18 No. 8 INSIGHTS 10, 10 (Aug., 2004). 665 See supra “CEO/CFO Certifications,” in notes 153–66. 666 Robert J. Lowe, et al., Employee Benefit Plans in Corporate Acquisitions, Dispositions and Mergers, in TAX

STRATEGIES FOR CORPORATE ACQUISITION, DISPOSITIONS, SPIN-OFFS, JOINT VENTURES, FINANCINGS, REORGANIZATIONS & RESTRUCTURINGS 271, 289–90 (Practicing Law Institute ed., 2004).

667 See Sharon D. Stuart, How Lawyers Use Financial Information, in BASICS OF ACCOUNTING & FINANCE

WHAT EVERY PRACTICING LAWYERS NEEDS TO KNOW 711, 717 (Practicing Law Institute ed., 2004). 668 The sample provisions set forth herein to address SOX issues are derived in large part from Lee Walton &

Joel Greenberg, The Impact of Sarbanes-Oxley on Merger and Acquisition Practices, Presentation at the Committee Forum of the ABA Negotiated Acquisitions Committee in Los Angeles (Apr. 5, 2003), http://www.abanet.org/buslaw/corporateresponsibility/clearinghouse/03spring/59/soxma.pdf.


United States (“GAAP”) (except, in the case of unaudited statements, to the extent permitted by Regulation S-X for Quarterly Reports on Form 10-Q) applied on a consistent basis during the periods and at the dates involved (except as may be indicated in the notes thereto) and fairly present the consolidated financial condition of the Company and its subsidiaries at the dates thereof and the consolidated results of operations and cash flows for the periods then ended (subject, in the case of unaudited statements, to notes and normal year-end audit adjustments that were not, or with respect to any such financial statements contained in any Company SEC Documents to be filed subsequent to the date hereof are not reasonably expected to be, material in amount or effect). Except (A) as reflected in the Company’s unaudited balance sheet at _______________ or liabilities described in any notes thereto (or liabilities for which neither accrual nor footnote disclosure is required pursuant to GAAP) or (B) for liabilities incurred in the ordinary course of business since _______________ consistent with past practice or in connection with this Agreement or the transactions contemplated hereby, neither the Company nor any of its subsidiaries has any material liabilities or obligations of any nature. Part ____ of the Company Disclosure Statement lists, and the Company has delivered to Parent copies of the documentation creating or governing, all securitization transactions and “off-balance sheet arrangements” (as defined in Item 303(c) of Regulation S-K of the SEC) effected by the Company or its subsidiaries since ____________. ____________, which has expressed its opinion with respect to the financial statements of the Company and its subsidiaries included in Company SEC Documents (including the related notes), is and has been throughout the periods covered by such financial statements (x) a registered public accounting firm (as defined in Section 2(a)(12) of the Sarbanes-Oxley Act of 2002) [“SOX”], (y) “independent” with respect to the Company within the meaning of Regulation S-X and, with respect to the Company, and (z) in compliance with subsections (g) through (l) of Section 10A of the 1934 Act and the related Rules of the SEC and the Public Company Accounting Oversight Board. Part ____ of the Company Disclosure Schedule lists all non-audit services performed by __________ for the Company and its subsidiaries since __________ [, all of which have been duly approved as required by Section 202 of SOX].

Internal Controls. The Company has implemented and maintains a system of internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the 1934 Act) sufficient to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP, including, without limitation, that (i) transactions are executed in accordance with management’s general or specific authorizations, (ii) transactions are recorded as necessary to permit preparation of financial statements in conformity with GAAP and to maintain asset accountability, (iii) access to assets is permitted only in accordance with management’s general or specific authorization,


and (iv) the recorded accountability for assets is compared with the existing assets at reasonable intervals and appropriate action is taken with respect to any differences.

SEC Reports. The Company has on a timely basis filed all forms, reports and documents required to be filed by it with the SEC since __________. Part ____ of the Company Disclosure Schedule lists, and, except to the extent available in full without redaction on the SEC’s web site through the Electronic Data Gathering, Analysis and Retrieval System (“EDGAR”) two days prior to the date of this Agreement, the Company has delivered to Parent copies in the form filed with the SEC of (i) the Company’s Annual Reports on Form 10-K for each fiscal year of the Company beginning since __________, (ii) its Quarterly Reports on Form 10-Q for each of the first three fiscal quarters in each of the fiscal years of the Company referred to in clause ____ above, (iii) all proxy statements relating to the Company’s meetings of stockholders (whether annual or special) held, and all information statements relating to stockholder consents since the beginning of the first fiscal year referred to in clause (i) above, (iv) all certifications and statements required by (x) the SEC’s Order dated June 27, 2002 pursuant to Section 21(a)(1) of the 1934 Act (File No. 4-460), (y) Rule 13a-14 or 15d-14 under the 1934 Act or (z) 18 U.S.C. § 1350 (§ 906 of SOX) with respect to any report referred to in clause (i) or (iii) above, (v) all other forms, reports, registration statements and other documents (other than preliminary materials if the corresponding definitive materials have been provided to Parent pursuant to this Section ____ filed by the Company with the SEC since the beginning of the first fiscal year referred to in clause (i) above (the forms, reports, registration statements and other documents referred to in clauses (i), (ii), (iii), (iv) and (v) above are, collectively, the “Company SEC Reports” and, to the extent available in full without redaction on the SEC’s web site through EDGAR two days prior to the date of this Agreement, are, collectively, the “Filed Company SEC reports”), and (vi) all comment letters received by the Company from the Staff of the SEC since __________ and all responses to such comment letters by or on behalf of the Company. The Company SEC reports (x) were or will be prepared in accordance with the requirements of the 1933 Act and the 1934 Act, as the case may be, and the rules and regulations thereunder and (y) did not at the time they were filed with the SEC, or will not at the time they are filed with the SEC, contain any untrue statement of a material fact or omit to state a material fact required to be stated therein or necessary in order to make the statements made therein, in the light of the circumstances under which they were made, not misleading. No Subsidiary of the Company is or has been required to file any form, report, registration statement or other document with the SEC. The Company maintains disclosure controls and procedures required by Rule 13a-15 or 15d-15 under the 1934 Act; such controls and procedures are effective to ensure that all material information concerning the Company and its subsidiaries is made known on a timely basis to the individuals responsible for the preparation of the Company’s filings with the SEC and other public disclosure documents. Part ____ of the Company


Disclosure Schedule lists, and the Company has delivered to Parent copies of, all written descriptions of, and all policies, manuals and other documents promulgating, such disclosure controls and procedures. To the Company’s knowledge, each director and executive officer of the Company has filed with the SEC on a timely basis all statements required by Section 16(a) of the 1934 Act and the rules and regulations thereunder since __________. As used in this Section ____, the term “file” shall be broadly construed to include any manner in which a document or information is furnished, supplied otherwise made available to the SEC.

Reports and Financial Statements – Certifications. The Chief Executive Officer and the Chief Financial Officer of the Company have signed, and the Company has furnished to the SEC, all certifications required by SOX Section 906; such certifications contain no qualifications or exceptions to the matters certified therein and have not been modified or withdrawn; and neither the Company nor any of its officers has received notice from any Governmental Entity questioning or challenging the accuracy, completeness, form or manner of filing or submission of such certifications.

Loans to Executives and Directors. The Company has not, since July 30, 2002, extended or maintained credit, arranged for the extension of credit, or renewed an extension of credit, in the form of a personal loan to or for any director or executive officer (or equivalent thereof) of the Company. Part ____ of the Company Disclosure Schedule identifies any loan or extension of credit maintained by the Company to which the second sentence of Section 13(k)(1) of the 1934 Act applies.

Legal Proceedings and Compliance with Laws. The Company is, or will timely be in all material respects, in compliance with all current and proposed listing and corporate governance requirements of the New York Stock Exchange, and is in compliance in all material respects, and will continue to remain in compliance following the Effective Time, with all rules, regulations and requirements of SOX or the SEC.

Each of the Company, its directors and its senior financial officers has consulted with the Company’s independent auditors and with the Company’s outside counsel with respect to, and (to the extent applicable to the Company) is familiar in all material respects with all of the requirements of, SOX. The Company is in compliance with the provisions of SOX applicable to it as of the date hereof and has implemented such programs and has taken reasonable steps, upon the advice of the Company’s independent auditors and outside counsel, respectively, to ensure the Company’s future compliance (not later than the relevant statutory and regulatory deadlines therefore) with all provisions of SOX which shall


become applicable to the Company after the date hereof.

Covenant Regarding Scope of Due Diligence. Between the date of this Agreement and the Closing Date, [the Company] shall permit Buyer’s senior officers to meet with the [officers of the Company] responsible for the Financial Statements, the internal controls of the Compan[y] and the disclosure controls and procedures of the Company to discuss such matters as Buyer may deem reasonably necessary or appropriate for Buyer to satisfy its obligations under Sections 302 and 906 of SOX and any rules and regulations relating thereto.

XIV. CONCLUSION

SOX and the SEC’s rules thereunder are having a significant impact on how issuers, both public and private, are governed and manage their disclosure processes. They are also having profound effects on the accountants, attorneys and other M&A professionals who deal with issuers, and their communications with each other.


EXHIBIT A:ATTORNEY-CLIENT PRIVILEGE AND THE WORK PRODUCT DOCTRINE IN THE CORPORATE CONTEXT

A. Introduction

Our system of jurisprudence is designed to facilitate resolving lawsuits based on what the facts reveal, not by what lawyers conceal. So that the real facts may be made known to all parties, the parties are permitted discovery from their opponents before trial begins. Each party may be called upon by his adversary or the court to, in effect, lay his cards on the table so that the dispute may be resolved on the basis of what all the cards show, rather than on the relative skill of the players. This philosophy is intended to level the tables between institutional litigants, perceived to have greater resources, and the individuals against whom they are often aligned. Countervailing considerations in the interests of fairness have produced a few limited exceptions to this policy of openness.

B. Attorney-Client Privilege

1. Overview

The attorney-client privilege is the oldest recognized privilege against discovery known to the common law. It traces its roots back to the reign of Elizabeth I in the 16th century669 during the days when a lawyer’s honor as a gentleman was paramount.670 The policy behind recognition of the privilege was most simply expressed by the United States Supreme Court in Upjohn Co. v. United States,671 where the Court characterized the purpose of the privilege as being “to encourage full and frank communication between attorneys and their clients and thereby promote broader public interests in the observance of law and administration of justice.”672 A more eloquent justification is found in the comment to Rule 210 of the American Law Institute’s Model Code of Evidence:

In a society as complicated in structure as ours and governed by laws as complex and detailed as those imposed upon us, expert legal advice is essential. To the furnishing of such advice the fullest freedom and honesty of communication of pertinent facts is a prerequisite. To induce clients to make such communications, the privilege to prevent their later disclosure is said by courts and commentators to be a necessity. The social good derived from the proper performance of the functions of lawyers acting for their clients is believed to outweigh the harm that may come from the suppression of the evidence in specific cases.673

669 See Kelway v. Kelway, (1580) 21 Eng. Rep. 47 (Ch.). 670 Because divulging confidences entrusted to him would do him dishonor, it was the attorney, not the client

who could exercise the privilege. The privilege now is considered to belong to the client, and not the lawyer. See Apex Mun. Fund v. N-Group Sec., 841 F. Supp. 1423 (S.D. Tex. 1993).

671 449 U.S. 383 (1981). 672 Id. at 389. 673 A.L.I. MODEL CODE OF EVID. R. 210 cmt., quoted in United States v. United Shoe Mach. Corp., 89 F. Supp.


Unfortunately, one of the complex and detailed laws referred to in the aforementioned comment turns out to be the attorney-client privilege itself. There are numerous requirements for the privilege to be applicable, and judicial interpretations differ from jurisdiction to jurisdiction and even from judge to judge.674

The attorney-client privilege protects communications of legal advice made (and kept) between attorneys and clients, including communications between corporate employees and a corporation’s attorneys to promote the flow of information between clients and their attorneys.675 Although the attorney-client privilege does not require ongoing or threatened litigation, it covers only “communications” between the lawyer and his client for the purposes of legal assistance.676

The core requirement of the attorney-client privilege is that the confidentiality of the privileged information be maintained. Therefore, the privilege is typically waived when the privilege holder discloses the protected information to a third party. A waiver of attorney-client privilege destroys the attorney-client privilege with respect to all future opposing parties and for the entire subject matter of the item disclosed.

Further, the attorney-client privilege does not protect all things that pass back and forth between attorneys and their clients under all circumstances. A number of the requirements and limitations of the attorney-client privilege are discussed in the subsections which follow.

2. Derivative Actions

There is an issue as to whether a shareholder or a partner may compel disclosure of matters protected by the attorney-client privilege on the theory that he is the “client” or at least a “representative of the client.” The leading shareholder case on this issue is Garner v. Wolfinbarger.677 In that case, the Court of Appeals for the Fifth Circuit concluded that a shareholder maintaining a derivative action may have access to matters protected by the

357, 358 (D. Mass. 1950). 674 The ABA reported:

So that lawyers and clients will know in advance what communications will and will not be protected, and can conform their conduct accordingly, courts have endeavored to draw the lines with some clarity. Of course, it is impossible to achieve absolute certainty. At the margins, the application of the privilege is not always clear, and indeed, treatises can and have been written on the privilege, its exceptions, its intricacies, and its areas of ambiguity. Further uncertainty results from the fact that the relevant case decisions (and, in some states, statutes) differ from jurisdiction to jurisdiction. With respect to federal proceedings, Congress has not codified the attorney-client privilege but has authorized ongoing common law development of this and other privileges. Pursuant to its authority under the Federal Rules of Evidence, the Supreme Court of the United States has consistently recognized and upheld the privilege. But the Supreme Court has resolved only a limited number of questions concerning the boundaries of the privilege, and on the remaining questions, different districts and circuits—and even different judges within a given federal district—may take different approaches.

The ABA Task Force on the Att’y-Client Privilege, Am. Bar Ass’n, Report of ABA’s Task Force on the Attorney-Client Privilege, 60 BUS. LAW. 1029, 1033 (2005).

675 Upjohn, 449 U.S. at 389–91. 676 Id. 677 430 F.2d 1093 (5th Cir. 1970), cert. denied, 401 U.S. 974 (1971).


attorney-client privileged if he can show “good cause.” The court set forth the circumstances by which good cause is to be judged, which include such factors as the number of shareholders involved, the percentage of ownership they represent, the nature of the claim being made and the allegations made against the corporate officers, and similar concerns.678 The Garner doctrine has been followed by some courts,679 but has been rejected as unnecessary by other courts, especially in light of the other exceptions to the attorney-client privilege, most notably the crime/fraud exception.680 Further, the Garner exception is only applicable to the attorney-client privilege and will not result in discovery if the item is also protected by the work product doctrine.681 In the partnership context, the courts have consistently held that the attorney-client privilege may not be used to deny a partner the right to inspect partnership records.682

678 Id. at 1103–04. 679 In re Fuqua Indus., Inc. Shareholders Litig., No. 11974, 2002 Del. Ch. LEXIS 52 at *12 (Del. Ch. May 2,

2002) (outlining that in the context of a derivative claim arising out of the Fuqua directors’ decision to except its principal shareholder from Delaware General Corporation Law § 203 (which restricts certain transactions with a 15% shareholder) and to authorize the repurchase of Fuqua shares allegedly for the purpose of enhancing the principal shareholder’s control without paying a change in control premium and entrenching the directors, Chancellor Chandler wrote Garner requires “mutuality of interest between the parties” at the time of the disputed communication; “because the director is obligated to act in the best interests of the corporation and its shareholders, there is a mutuality of interest among the director, the corporation and the shareholders when such legal advice is sought. . . . [U]pon a showing of good cause, the attorney-client privilege does not attach to prevent a plaintiff-shareholder—for whose ultimate benefit that advice was sought—from discovering the contents of [the] communication. . . . [W]hen the interests of the fiduciary diverge, however, there is no longer a mutuality of interest and a Garner analysis is not appropriate. . . . [T]hat divergence must necessarily occur . . . when the parties can reasonably anticipate litigation over a particular action”; “there is no Garner exception to the work product privilege”); Deutsch v. Cogan, 580 A.2d 100, 108 (Del. Ch. 1990) ( noting “[a] fiduciary owes an obligation to his beneficiaries to go about his duties without obscuring reasons from the legitimate inquiries of the beneficiaries”); cf. Commodity Futures Trading Comm’n v. Weintraub, 471 U.S. 343, 348 (1985).

680 See, e.g., Shirvani v. Capital Investing Corp., 112 F.R.D. 389, 390 (D. Conn. 1986). 681 Saito v. McKesson HBOC, Inc., No. 18553, 2002 Del. Ch. LEXIS 125 at 11 (Del. Ch. Oct. 25, 2002); In re

Fuqua Indus. Shareholders Litig., No. 11974, 2002 Del. Ch. LEXIS 52 at *20 (Del. Ch. May 2, 2002). 682 The courts that have considered the question whether a general partner may shield documents from its limited

partner have consistently held that it cannot. See Roberts v. Heim, 123 F.R.D. 614, 625 (N.D. Cal. 1988) (evaluating argument of limited partners of a partnership who sued the partnership’s general partners and its law firm to compel production of certain documents the defendants claimed were privileged; rejecting the defendant’s argument that, for purposes of the attorney-client privilege, the law firm’s clients were the general partners, the court held that the limited partners were clients of the law firm and were entitled to inspect all of the partnership’s records, including the documents generated by and sent to the partnership’s attorneys); Abbott v. The Equity Group, No. 86-4186, 1988 WL 86826 at *1 (E.D. La. 1988) (noting “[w]e begin by stating that a member of a partnership is entitled to disclosure of communications to and from an attorney representing the partnership in connection with partnership matters. Because of the relationship existing between partners in the creation of a partnership, which we view as stronger than that existing between stockholder and corporation, we conclude that the bar preventing disclosure of attorney communications, as between partners, is not simply relaxed, but non-existent. Partners therefore need not establish “cause” to discover privileged communications of an attorney in matters in which the partnership, of which they are members, is the client”); Ronson v. Superior Court, 29 Cal. Rptr. 2d 268, 280 (Cal. Ct. App. 1994) (noting that, because of mere “potential presence of implied attorney-client duties,” limited partner is entitled to production of documents concerning partnership business over privilege objection); Wortham & Van Liew v. Superior Court, 233 Cal. Rptr. 725, 725, 728 (Cal. Ct. App. 1987) (framing the issue as whether “the attorney for the partnership [could] withhold from a partner important information received from another partner concerning partnership transactions claiming the information is confidential under the attorney-client privilege,” holding that “[a]ll partners are entitled


3. Legal Advice Purpose

At the heart of the attorney-client privilege is the notion that communications are privileged in order to facilitate the delivery of legal advice. The privilege necessarily has encompassed communications that actually constitute legal advice as well as communications made for the purpose of seeking, obtaining or facilitating the rendition of legal advice. But the privilege does not protect all communications to or from an attorney,683 and does not prevent disclosure of the underlying facts.684 Accordingly, sending copies of documents to an attorney or including an attorney in a meeting will not automatically trigger the privilege.685 It is only where the attorney is acting in his capacity as an attorney, that is, as a legal advisor, that the privilege is applicable.686

In many circumstances, especially for inside counsel, the determination of whether an attorney is acting in his capacity as a legal advisor, or in some other role, will be difficult.687

access to a wide range of partnership information, whether or not that information is generated under the aegis of the partnership’s attorney,” and ordered the attorney to “divulge all partnership information to all partners”); McCain v. Phoenix Res., Inc., 230 Cal. Rptr. 25, 26-28 (Cal. Ct. App. 1986) (concluding that “a limited partner has the right to inspect all documents and papers affecting the partnership, including those held by the partnership’s attorney;” while recognizing that the attorney-client privilege could be asserted as to records relating to the “purely private or personal interest” of one of the partners, the court held the privilege would not bar disclosure of matters related to a partnership business “simply because such business was conducted through a law firm”); Adell v. Somers, Schwartz, Silver & Schwartz, P.C., 428 N.W.2d 26, 29 (Mich. App. 1988) (holding limited partner is “client” of partnership’s law firm and has standing to assert malpractice claim against attorney); but see Continental Ins. Co. v. Rutledge & Co., Inc., No. 15539, 1999 WL 66528 (Del. Ch. Jan. 26, 1999) (hearing dispute between general and limited partners over whether limited partners had right to withdraw from partnership pursuant to partnership agreement; limited partners sought to compel production by general partner of documents containing legal advice regarding the formation and internal affairs of the partnership; the Delaware Chancery Court found an absence of Delaware precedent and followed the Fifth Circuit’s corporate derivative action holding in Garner v. Wolfinbarger that allowed production upon a showing of “good cause” and the existence of a mutuality of interest between the parties; the required mutuality of interest was found lacking as to advice in connection with the formation of the partnership and after a dispute had arisen between the parties over the withdrawal issue that was the subject of the litigation).

683 See Thacker v. State, 852 S.W.2d 77 (Tex. App.—Austin 1993, writ denied). 684 Upjohn, 449 U.S. at 396 (noting client cannot “refuse to disclose any relevant fact within his knowledge

merely because he incorporated a statement of such fact into his communication to his attorney”); In re Six Grand Jury Witnesses, 979 F.2d 939, 944 (2d Cir. 1992) (noting communications between attorney and client regarding internal investigation into alleged fraud against government held privileged, but factual information contained in written communications between them, including results of investigation, were not privileged from discovery).

685 See, e.g., U.S. Postal Serv. v. Phelps Dodge Ref. Corp., 852 F. Supp. 156, 163–64 (E.D.N.Y. 1994) (stating that “[a] corporation cannot be permitted to insulate its files from discovery simply by sending a ‘cc’ to in-house counsel”); Int’l Tel. & Tel. Corp. v. United Tel. Co. of Fla., 60 F.R.D. 177, 185 (M.D. Fla. 1973) (finding that “the mere attendance of an attorney at a meeting, even where the meeting is held at the attorney’s instance, does not render everything done or said at that meeting privileged”).

686 See United States. v. Ackert, 169 F.3d 136 (2d Cir. 1999) ( discussing an attorney functioning as investment banker for Goldman Sachs & Co. (Goldman Sachs) who provided information as to tax implications of a proposed transaction to tax counsel for Paramount; recognizing that attorney-client privilege applies only to communications between an attorney and his client, court held that the attorney at Goldman Sachs was not functioning as an attorney and that the attorney-client privilege was not applicable even though the communication did assist Paramount’s attorney in representing his client); Teltron, Inc. v. Alexander, 132 F.R.D. 394 (E.D. Pa. 1990).

687 See Derek Lisk, When Does the Texas Attorney-Client Privilege Protect Communications With In-House


The difficulty may be increased when the attorney (whether inside or outside counsel) also serves as an officer688 or director689 of the corporation, because business advice is not

Counsel?, 68 TEX. BUS. J. 368 (2005); Todd Presnell, A Higher Standard: Claiming Attorney-Client Privilege is Tougher for In-House Counsel, 14 Bus. L. TODAY, No. 5 May-June 2005, at 19.

688 See Desert Orchid Partners LLC v. Transaction Sys. Architects, Inc., No. 8:02CV553, 2006 WL 1401683, at *3 (D. Neb. May 17, 2006) (holding redacted portion of audit committee minutes privileged based on attorney’s affidavit that the redacted portion related to matters on which the audit committee “sought legal advice, which he gave regarding the proper course of action to take about . . . [a]udit [c]ommittee activities” even though he was secretary and unredacted portions of the minutes related to unprivileged discussions of business transactions).

689 ABA Formal Opinion 98 410 (Feb. 1998) holds that a lawyer may serve as a director of client-business entities provided the following precautions are taken:

The Committee acknowledges that lawyers will continue to be asked and many will accept engagements as directors of client business entities and that it is not unethical for them to do so. It nevertheless is essential that lawyer-directors and their clients continue to be sensitive to the issues discussed in this opinion.

Though a lawyer serving in the dual role of corporate counsel and director is not subject to discipline absent a violation of a specific Rule, the following suggestions . . . should help to avoid a disciplinary infraction. The lawyer-director should:

1. Reasonably assure that management and the board of directors understand (i) the different responsibilities of legal counsel and director; (ii) that when acting as legal counsel, the lawyer represents only the corporate entity and not its individual officers and directors; and (iii) that at times conflicts of interest may arise under the rules governing lawyers’ conduct that may cause the lawyer to recuse herself as a director or to recommend engaging other independent counsel to represent the corporation in the matter, or to serve as co-counsel with the lawyer or her firm.

2. Reasonably assure that management and the board of directors understand that, depending upon the applicable law, the attorney-client evidentiary privilege may not extend to matters discussed at board meetings when the lawyer-director is not acting in her corporate counsel role and when other lawyers representing the corporation are not present in order to provide legal advice on the matters.

3. Recuse herself as a director from board and committee deliberations when the relationship of the corporation with the lawyer or her firm is under consideration, such as issues of engagement, performance, payment or discharge.

4. Maintain in practice the independent professional judgment required of a competent lawyer, recommending against a course of action that is illegal or likely to harm the corporation even when favored by management or other directors.

5. Perform diligently the duties of counsel once a decision is made by the board or management, even if, as a director, the lawyer disagrees with the decision, unless the representation would assist in fraudulent or criminal conduct, self-dealing or otherwise would violate the Model Rules.

6. Decline any representation as counsel when the lawyer’s interest as a director conflicts with her responsibilities of competent and diligent representation, for


privileged.

No bright-line tests have been developed for determining whether the attorney is acting as a legal advisor.690 Most courts have stated that, for a communication to be privileged, the lawyer must be acting “primarily” or “predominantly” as a lawyer,691 although business advice may be intermingled with the legal advice and still be privileged.692 One court defined “primarily legal” as requiring a showing that the communication “would not have been made but for the corporation’s need for legal advice or services.”693 Another court has stated that the “critical inquiry is whether, viewing the lawyer’s communication in its full content and context, it was made in order to render legal advice or services to the client.”694 By contrast, another court has held that legal advice may not be privileged if it is only incidental to business advice.695

Attorneys and clients recognize that statements made by an attorney to his client’s adversary in a negotiation are not privileged, but would expect that private communications between attorney and client in respect of the negotiation would be privileged. Many courts, however, have held that a lawyer conducting negotiations is not acting in a legal capacity and his communications and advice to his client, therefore, are not privileged.696 Undoubtedly, the notion that a negotiating lawyer is not acting in a legal capacity is surprising and alarming to all lawyers, not just to corporate counsel. The courts that have so held generally base their decision on the idea that the negotiation involves business judgment, not legal judgment. Fortunately, some courts have been more painstaking in their analysis and have concluded that

example, when the lawyer is so concerned over her personal liability as a director resulting from the course approved by management or the board that her representation of the corporation in the matter would be materially and adversely affected.

ABA Comm. on Ethics and Prof’l Responsibility, Formal Op. 98-410 (1998); See Micalyn S. Harris & Karen L. Valihura, Outside Counsel as Director: The Pros and Potential Pitfalls of Dual Service, 53 BUS. LAW. 479, 483–89 (1998).

690 In In re Tex. Farmers Ins. Exch., the Texarkana Court of Appeals held that communications between an insurance company and an attorney conducting for it a routine investigation of a fire of suspicious origin to determine whether a claim should be paid were not privileged because the attorney was not functioning as such at the time of the communications and the communications concerned bare facts, but that the privilege would apply to communications with the attorney concerning legal strategy, assessments and conclusions. 990 S.W.2d 337 (Tex. App.—Texarkana 1999, no pet.).

691 See, e.g., Sedco Int’l. S.A. v. Cory, 683 F.2d 1201, 1205 (8th Cir.), cert. denied, 459 U.S. 1017 (1982) (“primarily”); Arcuri v. Trump Taj Mahal Assoc., 154 F.R.D. 97, 102 (D.N.J. 1994) (“primarily”); Zenith Radio Corp. v. Radio Corp. of Am., 121 F. Supp. 792, 794 (D. Del. 1954) (“predominantly”).

692 See Pittsburgh Corning Corp. v. Caldwell, 861 S.W.2d 423 (Tex. App.—Houston [14th Dist.] 1993, no writ) (holding that the court was without authority to order privileged legal advice, opinions, or mental analysis in documents redacted and remainder produced).

693 Leonen v. Johns-Manville, 135 F.R.D. 94, 99 (D.N.J. 1990). 694 Spectrum Sys. Int’l Corp. v. Chemical Bank, 581 N.E.2d 1055, 1061 (N.Y. 1991). 695 United States v. Int’l Bus. Machines Corp., 66 F.R.D. 206, 210 (S.D.N.Y. 1974). 696 See, e.g., United States v. Wilson, 798 F.2d 509, 513 (1st Cir. 1986); Georgia-Pacific Corp. v. GAF Roofing

Mfg. Corp., No. 93 Civ. 5125, 1996 WL 29392, at *5 (S.D.N.Y. Jan. 25, 1996); J.P. Foley & Co. v. Vanderbilt, 65 F.R.D. 523, 526 (S.D.N.Y. 1974).


the negotiation did, in fact, involve a preponderance of legally significant issues, and therefore, was a privileged act.697 This idea is often referred to as “predominant purpose” test.698 Unfortunately, there are no bright line rules to identify the precise degree of legal advice necessary to satisfy the predominant purpose test.

4. Internal Investigations

Most courts agree in principle that an investigation conducted by counsel for the purpose of rendering legal advice is privileged.699 Generally speaking, though, the fact that a lawyer is involved in an investigation does not, standing alone, render the privilege applicable.700 However, determining whether an investigation is conducted for that purpose, or some other, can be difficult.

There are a number of cases involving the application of the attorney-client privilege701 to investigations conducted by counsel. In Upjohn, the privilege was held applicable when the investigation was conducted by “counsel for Upjohn acting as such, at the direction of corporate superiors in order to secure legal advice from counsel.”702 The Supreme Court quoted from the findings of the magistrate, who found: “[counsel] consulted with the Chairman of the Board and outside counsel and thereafter conducted a factual investigation to determine the nature and extent of the questionable payments and to be in a position to give legal advice to the company with respect to the payments.”703

697 In Note Funding Corp. v. Bobian Inv. Co., the court reasoned that “[i]f the attorney’s advice is sought, at least

in part, because of his legal expertise and the advice rests “predominantly” on his assessment of the requirements imposed, or the opportunities offered, by applicable rules of law, he is performing the function of a lawyer.” No. 93 Civ. 7427 (DAB), 1995 WL 662402, at *3 (S.D.N.Y. Nov. 9, 1995).

698 See, e.g. McCormick v. Sup. Court, Cal. Court. App. 5th Dist. No. F029503 (1998) (holding internal memos prepared by law firm in anticipation of becoming a defendant in a malpractice case not privileged).

699 Report of ABA’s Task Force on the Attorney-Client Privilege, 60 BUS. LAW. 1029, 1036 (May 2005). 700 See Seibu Corp. v. KPMG LLP, No. 3-00-CV-1639-X, 2002 U.S. Dist. LEXIS 906 at *9-10 (N.D. Tex. 2002)

(noting the “critical inquiry is whether . . . any particular communication in connection with [the] investigation facilitated the rendition of legal advice to the client”); Wells Fargo Bank v. Sup. Court, 22 Cal. 4th 201, 210 (2000) (noting “a client may be examined at deposition or at trial as to facts of the case, whether or not he has communicated them to his attorney”).

701 Other privileges, more appropriate to rely upon, are often implicated, but are not discussed here. These might include the work product doctrine and the party communication privilege. There is no general “privilege of self-critical analysis” applicable to compliance manuals, internal audit findings, outside accountants’ reports, management letters, and an outside accounting firm’s review of internal controls and compliance. See Dowling v. Am. Haw. Cruises, Inc., 971 F.2d 423, 425–26 (9th Cir. 1992) (finding no protection for routine internal safety reviews prior to the accident); Note, The Privilege of Self-Critical Analysis, 96 HARV. L. REV. 1083 (1983). But see In re Crazy Eddie Sec. Litig., 792 F. Supp. 197, 205–06 (E.D.N.Y. 1992) (finding accounting firm’s internal review of its audit, peer review report and letter of comments on internal quality controls protected). The Texas Legislature has recognized the value of critical self evaluation in certain areas when it adopted the Environmental, Health, and Safety Audit Privilege Act which appears at Tex. Rev. Civ. Stat. Ann. art. 4447cc (Vernon 1998); other states have similar statutes but the Environmental Protection Agency does not recognize the privilege. See Egan, Byron F., Miscellaneous Updates—“Ten Other Laws You Should Know About,” State Bar of Texas Professional Development Legislative Update Institute (Sept. 1995).

702 Upjohn Co. v. United States, 449 U.S. 383, 394 (1981). 703 Id. (emphasis in original).


By contrast, the court in Mission National Insurance Co. v. Lilly704 found the results of an investigation conducted by outside counsel not privileged. There, the outside lawyers were hired by an insurance company “as a matter of course to conduct its claims adjustment investigations in a geographic area including Minnesota for all claims exceeding $25,000.”705 Thus, the court concluded that the lawyers were simply performing the business function of claims investigation, as opposed to any legal function.706

The touchstone of an investigation that constitutes an attorney-client privileged exercise seems to be the attorney’s role as legal adviser. Where the investigation truly can be shown to have been conducted for the purpose of collecting the data necessary to render legal advice, then communications made during the investigation will be deemed privileged.707 On the other hand, when a lawyer is used merely in the hope that the investigation will be privileged, most courts will not find the privilege exists.708 The safest practice is to document the reason for conducting the investigation, and include in all written communications some prefatory notation regarding the purpose for the communication along with the requirement that it be kept confidential.709

While an internal investigation conducted by counsel may be privileged, there are pressures by auditors to give them access to privileged materials developed during the investigation.710 The materials sought by the auditors may include privileged materials such as the investigating counsel’s notes of interviews, legal assessments and advice to the client, as well as factual information such as documents received and transcripts of interviews which may not be protected.711 The auditors pressure may be attributed in part due to their obligations under 1934 Act § 10A712 and the potential relevance to the issuer’s internal controls.713

The U.S. Department of Justice (“DOJ”), the SEC and other federal and state governmental agencies are increasingly asking issuers under investigation to produce privileged materials, including materials developed in connection with internal investigations

704 112 F.R.D. 160, 164 (D. Minn. 1986). 705 Id. at 162. 706 See also In re Tex. Farmers Insur. Exch., 990 S.W.2d 337, 341 (Tex. App.—Texarkana 1999, no pet.)

(holding communications between insurance company and an attorney functioning as an investigator not privileged because the attorney was not functioning as such at the time of the communications).

707 See, e.g., In re LTV Sec. Litig., 89 F.R.D. 595 (N.D. Tex. 1981); Spectrum Sys. Int’l Corp. v. Chem. Bank, 581 N.E.2d 1055 (N.Y. 1991).

708 But see Diversified Indus., Inc. v. Meredith, 572 F.2d 596, 602 (8th Cir. 1977), rev’d en banc, 572 F.2d 596, 610 (8th Cir. 1978) (finding that use of an attorney is prima facie evidence of privilege).

709 For example: “This interview is conducted by counsel for XYZ, Inc. for the purpose of ascertaining facts needed in order to render legal advice to XYZ, Inc. This document is a confidential, attorney-client privileged communication; the contents of this document should not be disclosed other than to [insert names or titles].” In addition, inclusion of statements relevant to showing work product also might be helpful. E.g. “This document is prepared by counsel in anticipation of litigation for the purpose of facilitating the defense or prosecution of litigation.”

710 Report to the ABA House of Delegates, ABA Task Force on the Attorney-Client Privilege (June 14, 2006). 711 See supra Part V. 712 See supra notes 18–25 and accompanying text. 713 See supra note 710, at 10.


conducted by counsel, in order to show cooperation with the government in an effort to discourage prosecutorial or enforcement actions. This practice is supported by then Deputy Attorney General Larry Thompson’s January 20, 2003 memorandum (the “Thompson Memorandum”) to the DOJ addressing the “Principles of Federal Prosecution of Business Organizations.”714 The Thompson Memorandum identified nine factors that federal prosecutors should utilize in making their charging decisions regarding corporations or other business entities, including the corporation’s timely and voluntary disclosure of wrongdoing and its willingness to cooperate in the investigation of its agents, including, if necessary the waiver of corporate attorney-client and work product protection.

As a practical matter, corporations rarely can resist prosecutorial requests for disclosure, because of the harsh consequences of having to defend against criminal charges, and because, in cases where criminal charges are brought and sustained, corporations depend on the leniency in sentencing that results from providing assistance satisfactory to the prosecution, which was reinforced by the November 1, 2004 amendments to the Commentary for Chapter 8, Section 8C2.5 of the Guidelines, to qualify for a reduction in its sentence for providing assistance to the government investigation, a corporation would be required to waive confidentiality protections if “such waiver is necessary in order to provide timely and thorough disclosure of all pertinent information known to the organization.715

The SEC and other regulators have adopted policies and practices mirroring those of the Thompson Memorandum, which while discussing “cooperation credit,” mention disclosures of protected confidential information.716

Turning over privileged materials from an internal investigation may result in a waiver of the privilege,717 at least for the materials furnished.718

714 Memorandum from Deputy Attorney General Larry Thompson to Heads of Department Components and U.S.

Attorneys, Principles of Fed. Prosecution of Bus. Orgs. (Jan. 20, 2003), available at http://www.usdoj.gov/dag/cftf/corporate_guidelines.htm (expanded and revised previous policies of the DOJ that were established in a memorandum drafted by former Deputy Attorney General Eric Holder). Memorandum from Deputy Attorney General Eric Holder to Head of Department Components and U.S. Attorneys, Bringing Criminal Charges Against Corps. (June 16, 1999), reprinted in Justice Dep’t Guidance on Prosecution of Corps., 66 CRIM. L. REP. (BNA) 189 (1999), available at http://www.usdoj.gov/criminal/fraud/policy/Chargingcorps.html.

715 U.S. SENTENCING GUIDELINES MANUAL § 8C2.5 (2004), available at http://www.ussc.gov/2004guid/8c2_5.htm (emphasis added); Report to the ABA House of Delegates, ABA Task Force on the Attorney-Client Privilege (June 14, 2006) at 15.

716 Report to the ABA House of Delegates, supra note 710, at 16-17; Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934 and Commission Statement on the Relationship of Cooperation to Agency Enforcement Decisions, Exchange Act Release No. 44,969, 76 SEC Docket 220 (Oct. 23, 2001).

717 In re Qwest Communs. Int’l Inc. Secs Litig., 450 F.3d 1179, 1185, 1196 (10th Cir. 2006) (finding Qwest Communications’ voluntary disclosure of sensitive documents to the DOJ and SEC waived the attorney-client privilege and work product protection as to third parties who seek the documents in civil litigation against the company; surveying case law from other circuits and weighing policy arguments, the court found no basis for embracing the concept of “selective waiver” in this case and that the company’s confidentiality agreements with the agencies did little to prevent further dissemination of the privileged materials). See infra notes 723–52 and accompanying text.

718 See supra notes 545–57 and accompanying text; see also infra notes 738–51 and accompanying text.


5. Generally Unprivileged Items

Consistent with the idea that the communication must be for the purpose of rendering or facilitating legal advice, various types of information relating to the attorney-client relationship or otherwise in the possession or knowledge of the attorney are not considered privileged. These include the identity of the client,719 fee arrangements,720 factual circumstances surrounding the communication,721 and billing statements.722

6. Waiver

The privileged nature of an attorney-client communication must be preserved by not voluntarily disclosing the privileged communication to third parties723 or injecting it as an issue in litigation.724 The privilege belongs to the client, and only may be waived by the client or by the attorney as agent for the client.725

Compelled disclosure does not constitute a waiver.726 Governmental authorities are increasingly putting pressure on corporations to “voluntarily” provide privileged information to them in order to show the cooperation with their investigations and thereby receive less harsh treatment.727

719 See In re Grand Jury Subpoena Served upon Doe, 781 F.2d 238, 248 (2d Cir.) (en banc), cert. denied, Roe v.

United States, 475 U.S. 1108 (1986); Humphreys, Hutcheson and Mosely v. Donovan, 755 F.2d 1211 (6th Cir. 1985). But see In re Grand Jury Proceedings (Jones), 517 F.2d 666, 672 (5th Cir. 1975) (finding identity protected to the extent it constitutes last link to inculpate client).

720 See In re Two Grand Jury Subpoenae Duces Tecum, 793 F.2d 69, 71–72 (2d Cir. 1986). 721 See Condon v. Petacque, 90 F.R.D. 53, 54 (N.D. Ill. 1981). 722 See Clarke v. Am. Commerce Nat’l Bank, 974 F.2d 127, 130 (9th Cir. 1992). 723 See, e.g., United States v. Stewart, 287 F. Supp. 2d 461, 464 (S.D.N.Y. 2003) (finding Martha Stewart lost the

attorney-client privilege covering her e-mail to her lawyer by sharing it with her own daughter); Stenovich v. Wachtell, Lipton, Rosen & Katz, 756 N.Y.S.2d 367, 378–79 (N.Y. App. Div. 2003) (finding attorney-client privilege lost as to communications shared with corporation’s investment bankers); United States v. El Paso Co., 682 F.2d 530, 540–41 (5th Cir. 1982), cert. denied, 466 U.S. 944 (1984) (finding disclosure to outside auditors of internal tax analysis in which attorneys participated constituted waiver of attorney-client privilege); In re John Doe Corp., 675 F.2d 482, 488–89 (2d Cir. 1982) (finding disclosure of internal report to outside auditors and underwriters constituted waiver of the attorney-client privilege).

724 See McIntyre v. Main St. & Main Inc., No. C-99-5328 MJJ (EDL), 2000 U.S. Dist. LEXIS 19617 at 9 (N.D. Cal. 2000) (noting “[p]laintiffs are correct that defendant cannot rely on the investigation by outside counsel as part of its defense, while at the same time shielding the investigation from discovery. Any use of the investigation in its defense would waive the privilege.”); Wellpoint Health Networks v. Superior Court, 59 Cal. App. 4th 110, 129 (1997) (finding employer was not entitled to engage an attorney to conduct an investigation, cite the investigation as a defense, and then selectively produce only those portions of the investigation file that it deemed not to be privileged).

725 Report of ABA’s Task Force on the Attorney-Client Privilege, 60 BUS. LAWYER 1029, 1041 (2005). 726 See TEX. R. EVID. 512 (2007). See also In re Vargas, 723 F.2d 1461, 1466 (10th Cir. 1983) (noting

production of documents in response to a court order is not necessarily a voluntary disclosure constituting waiver). 727 Memorandum from Deputy Attorney General Larry Thompson to Heads of Department Components and U.S.

Attorneys, Principles of Fed. Prosecution of Bus. Orgs. (Jan. 20, 2003), available at http://www.usdoj.gov/dag/cftf/corporate_guidelines.htm (identified nine factors that federal prosecutors should utilize in making their charging decisions regarding corporations or other business entities, including the corporation’s timely and voluntary disclosure of wrongdoing and its willingness to cooperate in the investigation of its agents, including, if


7. No Waiver Where Common Interest

Voluntary disclosure of a privileged communication to a person with a common interest does not constitute waiver.728 Thus, communications between a lawyer for a parent corporation and an employee of a wholly-owned subsidiary usually are considered privileged.729 Similarly, multiple clients represented by the same attorney may talk freely with their attorney without fear that the presence of more than one client will constitute a waiver as to third parties.730

Disclosure to lawyers or clients in a joint defense situation also does not create waiver.731

necessary, the waiver of corporate attorney-client and work product protection); U.S. SENTENCING GUIDELINES

MANUAL § 8C2.5 (2004) (emphasis added), available at http://www.ussc.gov/2004guid/8c2_5.htm (to qualify for a reduction in its sentence for providing assistance to the government investigation, a corporation may be required to waive confidentiality protections if “such waiver is necessary in order to provide timely and thorough disclosure of all pertinent information known to the organization”); Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934 and Commission Statement on the Relationship of Cooperation to Agency Enforcement Decisions, Exchange Act Release No. 44,969, 76 SEC Docket 220 (Oct. 23, 2001), available at http://www.sec.gov/litigation/investreport/34-44969.htm (the “Seabord Report”) (stating that in determining whether to initiate SEC enforcement proceedings, the SEC considers the seriousness of the conduct; whether the company had “cooperate[d] completely with appropriate regulatory and law enforcement bodies”; whether the company had conducted “a thorough review of the nature, extent, origins and consequences of the conduct and related behavior”; whether the company “promptly [made] available to [SEC] staff the results of its review and provide[d] sufficient documentation reflecting its response to the situation”; whether “the company identif[ied] possible violative conduct and evidence with sufficient precision to facilitate prompt enforcement actions against those who violated the law”; whether “the company produce[d] a thorough and probing written report detailing the findings of its review”; and whether “the company voluntarily disclose[d] information [SEC] staff did not directly request and otherwise might not have uncovered.”); Report of ABA’s Task Force on the Attorney-Client Privilege, 60 BUS. LAW. 1029, 1043–52 (May 2005) (discussing these recent governmental policies, practices and procedures, and the implications thereof to the attorney-client privilege and the public policies underlying it). See William W. Horton, A Transactional Lawyer’s Perspective on the Attorney-Client Privilege: A Jeremiad for Upjohn, 61 BUS. LAW. 95 (2005) (noting officers and employees of corporations need confidence that attorney-client privilege will protect the confidence of their communications with their counsel (both inside and outside) so that they will provide counsel with the candid information needed to keep the corporation out of trouble); see also Molly McDonough, Justice Memo Stirs Up Another Storm—NY Judge Asks Whether Prosecutors Pressed Firm to Cut Off Legal Fees, ABA Journal eReport (Apr. 28, 2006), available at http://www.abanet.org/journal/ereport/a28thomson.html.

728 See United States v. Zolin, 809 F.2d 1411, 1417 (9th Cir. 1987), opinion withdrawn in part and reinstated in part by United States v. Zolin, 842 F.2d 1135 (9th Cir. 1988) (finding in tax fraud case involving L. Ron Hubbard, that attorney-client privilege had not been waived by presence of members of Church of Scientology at meetings with attorney because the persons present had a common interest in sorting out the respective affairs of the Church and Mr. Hubbard, commenting that “[e]ven where the non-party who is privy to the attorney-client communications has never been sued on the matter of common interest and faces no immediate liability, it can still be found to have a common interest with the party seeking to protect the communications.”).

729 See In re Grand Jury Subpoenas, 89-3 and 89-4, John Doe 89-129, 902 F.2d 244, 250 (4th Cir. 1990); Admiral Ins. Co. v. U.S. Dist. Court, 881 F.2d 1486, 1493 n.6 (9th Cir. 1989); Bowne, Inc. v. AmBase Corp., 150 F.R.D. 465, 491 (S.D.N.Y. 1993).

730 See In re Auclair, 961 F.2d 65, 69 (5th Cir. 1992). 731 The courts have developed two doctrines of exceptions to the waiver of the privilege through voluntary

disclosure. Wilson P. Abraham Constr. Corp. v. Armco Steel Corp., 559 F.2d 250, 253 (5th Cir. 1977); Ryals v. Canales, 767 S.W.2d 226, 228 (Tex. App.—Dallas 1989, no writ). The joint defendant rule, embodied in Uniform Rule of Evidence 502(b)(5), protects communications relevant to a matter of common interest between two or more


In the event the clients in the joint defense arrangement later become adverse to each other, their communications, which were privileged as to third parties, are not privileged in the controversy between them.732 As a consequence, attorneys whose clients are entering into a joint defense arrangement and sharing otherwise privileged information have an ethical duty to advise their clients of this risk of privilege loss.

8. Issue Injection

Another means of waiver is through offensive use, sometimes also called issue injection. The rule is simple, although sometimes difficult to implement. A client may not make an

clients of the same lawyer from disclosure. UNIF. R. EVID. sec. 502 (d)(5)(1994). This widely accepted doctrine applies strictly to clients of the same lawyer who are joint defendants in litigation. Several courts have expanded the joint defense doctrine in order to create another exception to the waiver of attorney-client privilege: the doctrine of common-interest. Under the common interest doctrine, privileged information can be disclosed to a separate entity that has a common legal interest with the privilege holder, whether or not the third party is a co-defendant. Federal circuit courts and state courts diverge in their interpretation and application of the common interest and joint defendant doctrine. United States v. Weissman, No. S1 94 CR. 760 CSH, 1996 WL 737042, at *7 (S.D.N.Y. Dec. 26, 1996). In the most expansive application of the common interest doctrine, courts exclude a waiver of the attorney-client privilege when there is a common interest between the disclosing party and the receiving party, and parties have a reasonable expectation of litigation concerning their common interest. See Hewlett-Packard Co. v. Bausch & Lomb, 115 F.R.D. 308, 309 (N.D.Cal. 1987). More restrictive courts require that the parties share an identical legal, as opposed to purely commercial, interest. See Duplan Corp. v. Deering Milliken, 397 F. Supp. 1146, 1172 (D.S.C. 1974). Finally, some courts persist in rejecting the common interest theory absent actual or pending litigation in which both parties are or will be joint defendants. See Int’l Ins. Co. v. Newmont Mining Corp., 800 F. Supp. 1195, 1196 (S.D.N.Y. 1992). Although there is no uniform test for application of the common interest doctrine, courts have consistently examined three elements when applying the doctrine: (1) whether the confidentiality of the privileged information is preserved despite disclosure; (2) whether, at the time that the disclosures were made, the parties were joint defendants in litigation or reasonably anticipated litigation; and (3) whether the legal interests of the parties are identical or at least closely aligned at the time of disclosure. See, e.g. United States v. Gulf Oil Corp., 760 F.2d 292, 296 (Temp. Emer. Ct. App. 1985). The core requirement of the common interest doctrine is the existence of a shared legal interest. Courts will have less difficulty in finding an exception to a waiver when the parties actively pursue common legal goals. See United States v. Schwimmer, 892 F.2d 237, 243–44 (2d Cir. 1989). An asset purchase agreement in which the buyer does not assume the litigation liability of the seller does not demonstrate an alignment of the parties’ interests. A common business enterprise, such as the sale of assets, or a potential merger, will not suffice unless the parties’ legal interests are at least parallel and non-adverse. Jedwab v. MGM Grand Hotels, Inc., No. 8077, 1986 WL 3426, at * 2 (Del. Ch. Mar. 20, 1986). Disclosures by a corporation and its counsel to the corporation’s investment banking firm during merger discussions have resulted in a waiver of the attorney-client privilege because the common interest rule did not apply. See Blanchard v. EdgeMark Fin. Corp., 192 F.R.D. 233, 237 (N.D. Ill. 2000). The court said the common-interest rule protects from disclosure those communications between one party and an attorney for another party “where a joint defense effort or strategy has been decided upon and undertaken by the parties and their respective counsel,” noting that the common interest must be a legal one, not commercial or financial. Id. at 237. The court concluded, however, that the common interest rule did not apply because the defendants did not demonstrate that the investment banking firm’s legal interest in the threatened litigation was anything more than peripheral. Id.

732 See Garner v. Wolfinbarger, 430 F.2d 1093, 1103 (5th Cir. 1970) (noting that “[i]n many situations in which the same attorney acts for two or more parties having a common interest, neither party may exercise the privilege in a subsequent controversy with the other. This is true even where the attorney acts jointly for two or more persons having no formalized business arrangement between them.”).


affirmative claim for relief, assert privilege as to an outcome determinative matter, and deny the adverse party its only means of discovering the information.733 The key to this test is whether the privileged matter is outcome determinative. If so, the client is given the choice of disclosing the privileged information or abandoning his claim.734

Clients may assert a defense based on their good faith belief that their actions were in conformity with applicable laws. Often the good faith can be shown only by showing that the action was in reliance on advice of counsel. Once the client opens the issue of the advice received by selectively revealing any of the advice it received, the client risks placing at issue, and waives the privilege as to, all steps it took to comply with the law at issue.735 Such a waiver can result in both the client and the attorney being compelled to submit to deposition and testimony at trial.736

733 Republic Ins. Co. v. Davis, 856 S.W.2d 158, 163 (Tex. 1993). 734 Cf. Texas Dep’t. of Pub. Safety Officers Ass’n v. Denton, 897 S.W.2d 757, 760 (Tex. 1995) (involving

offensive use of Fifth Amendment privilege). 735 See Nguyen v. Excel Corp.,which noted:

A corporate client has a privilege to refuse to disclose, and prevent its attorneys from disclosing, confidential communications between its representatives and its attorneys when the communications were made to obtain legal services. A client waives the attorney-client privilege, however, by failing to assert it when confidential information is sought in legal proceedings. Inquiry into the general nature of the legal services provided by counsel does not necessitate an assertion of the privilege because the general nature of services is not protected by the privilege. Further inquiry into the substance of the client’s and attorney’s discussions does implicate the privilege and an assertion is required to preserve the privilege. A client’s specific request to an attorney and pertinent information related thereto fall within the reaches of the privilege. Additionally, the research undertaken by an attorney to respond to a client’s request also falls within the reaches of the privilege.

Though Excel raised some privilege-based objections, it did not object to all questions designed to elicit information about privileged communications. The district court observed that Excel did not object to all questions designed to elicit information about confidential communications, and that Excel did not halt its executives’ responses to all such questions. . . . Excel waived the attorney-client privilege by its failure to assert the privilege.

As related, but alternative, grounds for affirming the district court’s order, Excel waived the attorney-client privilege by selectively disclosing confidential communications. When relayed to a third party that is not rendering legal services on the client’s behalf, a communication is no longer confidential, and thus it falls outside of the reaches of the privilege. Therefore, a client implicitly waives the attorney-client privilege by testifying about portions of the attorney-client communication.

197 F.3d 200, 206–07 (5th Cir. 1999). But see In re Carbo Ceramics, Inc., 81 S.W.3d. 369, 378–79 (Tex. App.—Houston [14th Dist.] 2002, no pet.) (stating that “Texas courts apply the offensive use doctrine when the advice of counsel defense is raised) (citations omitted). The offensive use doctrine applies when a party seeking affirmative relief attempts to claim a privilege to shield evidence that would materially weaken or defeat that party’s claims. [Citation omitted]. ‘A plaintiff cannot use one hand to seek affirmative relief in court and with the other lower an iron curtain of silence against otherwise pertinent and proper questions which may have a bearing upon his right to maintain his action. . . .’ Texas courts define affirmative relief narrowly for the purpose of determining whether offensive use commands the waiver of privilege.”).

736 See Excel, which noted:

Excel next maintains that, even if it waived the privilege, its executives rather than its counsel should be deposed regarding matters no longer privileged. Excel encourages this court to adopt the inquiry of the Eighth Circuit [in Shelton v. Am. Motors Corp., 805 F.2d 1323 (8th Cir. 1986)] and forbid a party from deposing opposing counsel unless (1) no other means exist to obtain the information, (2) the information sought is relevant and non-privileged, and (3) the information is crucial to the preparation of the case. Excel contends that appellees cannot establish any of the three


9. Scope of Waiver

Concerns about waiving privilege surround communications with accountants, underwriters and prospective merger partners regarding litigation loss contingencies. In each of those communications, there is a voluntary disclosure that is necessary for the corporation to accomplish its business. Yet, when documents or other communications are disclosed to persons outside the scope of the attorney-client privilege, waiver of the privilege occurs. The issue involves how far the waiver goes.

The scope of waiver is broad. It is generally considered to be permanent, that is, the privilege cannot be reclaimed in another circumstance or proceeding.737 Furthermore, the waiver may extend not only to the document or communication specifically disclosed, or to which the privilege was waived, but to all communications on the “subject matter.”738

In In re Grand Jury Proceedings,739 the Court addressed the issue of whether a corporate officer inadvertently waived attorney-client privilege to the entire subject matter of communications with their lawyer about a particular matter when they disclosed certain portions of the attorney’s advice to a government agent. In making their determination, the court allowed discovery of certain information, disallowed discovery of other information, and specifically instructed the lower court to conduct further proceedings in order to determine what other information came within the “subject matter” of the information disclosed:

[T]wo government investigators met with [a company’s] owner and president. Shortly after the meeting began, the owner and president informed the agents that they had met with a Washington, D.C. attorney who specializes in Medicare law, and

criteria.

. . .

Because depositions of opposing counsel are disfavored generally and should be permitted in only limited circumstances, one would suspect that a request to depose opposing counsel generally would provide a district court with good cause to issue a protective order. The district court, however, did not abuse its discretion in authorizing the depositions of defense counsel, even assuming the applicability of the Shelton inquiry.

. . .

The second sentence of the magistrate judge’s order permits inquiry into counsels’ understanding of defendant’s perceptions, and the third sentence of the order permits inquiry into counsels’ opinions. These inquiries are impermissible. “An attorney’s thoughts [are] inviolate. . . .” Even though an attorney’s mental impressions and opinions fall outside of the attorney-client privilege, they also “fall[] outside the arena of discovery [as their disclosure would] contravene[ ] the public policy underlying the orderly prosecution and defense of legal claims.”

197 F.3d at 208–10. 737 See United States v. Suarez, 820 F.2d 1158, 1160 (11th Cir. 1987), cert. denied, 484 U.S. 987 (1987). 738 8 J. WIGMORE, EVIDENCE § 2328, at 638 (McNaughton rev. ed. 1961). See also United States v. Davis, 636

F.2d 1028, 1044 n.18 (5th Cir.), cert. denied, 454 U.S. 862 (1981); Zielinski v. Clorox Co., 504 S.E.2d 683, 685–86 (Ga. 1998) (holding that attorney-client privilege was waived as to the subject matter of certain documents turned over to the district attorney’s office as part of an ongoing embezzlement investigation).

739 78 F.3d 251 (6th Cir. 1996).


they told the investigators the attorney’s name. They told the agents that they brought their twenty-four point marketing plan to the attorney and that they described the various elements of the plan to her in detail.

. . .

The owner and president told the investigators that their attorney was concerned that providing free Sharps needle disposal containers could constitute an illegal inducement or kickback. But, the president noted, the attorney had no problem with the laboratory billing Medicare for tests done by nursing home personnel or with providing nursing homes free glucose testers and lancets. When asked by the agents about the apparent inconsistency between the lawyer’s advice regarding free Sharps disposal containers and free glucose testers, the president responded, “That’s the advice I had of the attorney at the time.”

The District Court held that the owner and president had waived the attorney-client privilege by voluntarily disclosing the substance of their attorney’s advice to the government agents. The District Court also held that “the government’s motion to compel is granted to the extent of the legal advice and documents relating to [the laboratory’s] marketing plan.”

. . .

Having concluded that the attorney-client privilege was waived as to specific elements of the marketing plan, we must now determine the scope of that waiver.

. . .

In support of the District Court’s order, the Government argues that “[i]t is well established that voluntary disclosure of the content of a privileged communication constitutes a waiver of the privilege as to all other such communication on the same subject matter.” The government relies on several cases to support its claim that in view of the waiver on specific items of the marketing plan, the laboratory waived its privilege with respect to the rest of the plan. See, e.g., United States v. Jones, 696 F.2d 1069, 1072 (4th Cir.1982) (“Any voluntary disclosure by the client to a third party waives the privilege not only as to the specific communication disclosed, but often as to all other communications relating to the same subject matter.”); In re Sealed Case, 676 F.2d 793, 818 (D.C.Cir.1982) (“When a party reveals part of a privileged communication in order to gain an advantage in litigation, it waives the privilege as to all other communications relating to the same subject matter . . .”); Edwards v. Whitaker, 868 F.Supp. 226, 229 (M.D.Tenn.1994) (“[V]oluntary disclosure of the content of a privileged attorney communication constitutes waiver of the privilege as to all other such communications on the same subject.”).


. . .

[T]he government may ask questions that clearly pertain to the subject matter of the specific points on which a waiver did occur. The District Court will have to decide whether the remaining points in the marketing plan are truly the same subject matter as those in the specific marketing plan points on which there was a waiver and approve or disallow questions on that basis.740

While In re Grand Jury Proceedings adopts the subject matter test, only one court has given much guidance in determining what is and what is not in the same subject matter when disclosure of some privileged communications has taken place. In a series of opinions arising from the case styled United States v. Skeddle,741 a U.S. District Court in Ohio addressed the scope of a corporation’s waiver to its claim of attorney-client privilege. The case arose in the context of a criminal charge of wire and mail fraud against former employees of Libbey Owens Ford Co. (“LOF”) arising out of their allegedly improper self-dealing transactions with LOF. LOF’s general counsel became suspicious of defendants’ activities and began an internal investigation which led to LOF commencing civil litigation against the criminal defendants and others. In connection with the general counsel’s trial testimony in the criminal case, LOF agreed to waive its attorney-client privilege as to communications between the general counsel and LOF management prior to his discovery of the allegedly fraudulent activities, but refused to waive the privilege as to communications related to its internal investigation and litigation against defendants.742 The general counsel then testified at the criminal trial of the former LOF employees regarding conversations he had with other LOF officials as to which LOF had expressly waived its attorney-client privilege. The defendants claimed that this testimony waived the corporation’s attorney-client privilege as to the entire contents of the investigative file.743

Exhibiting a judicial tendency to narrowly construe the subject matter as to which the privilege has been waived, the court noted that the general counsel’s file covered three stages in respect of the case: (i) an “implementation” phase during which the legal department was communicating with management as the transactions at issue were being developed in the apparent ordinary course of business, (ii) an “investigatory phase” that began when LOF had significant reason to believe wrongdoing had occurred, and (iii) a “litigation” phase after LOF had decided to file suit to recover the value defendants had wrongfully obtained. The court then held that LOF could waive its privilege as to the implementation phase without any waiver as to the investigatory and litigation phases. The court noted that in the implementation phase, the legal department lawyers were working with defendants in the transaction in the ordinary course, perhaps acting in the dual role of lawyer and businessman, and were involved as the facts at issue were developing. In the investigatory and litigation phases, the legal department was endeavoring to assert the interests of LOF against defendants. In so holding,

740 Id. at 253–56 (emphasis added). 741 United States v. Skeddle, 989 F. Supp. 905 (N.D. Ohio 1997) (Skeddle I); 989 F. Supp. 913 (N.D. Ohio 1997)

(Skeddle II); 989 F. Supp. 917 (N.D. Ohio 1997) (Skeddle III). 742 Skeddle I, 989 F. Supp. at 908. 743 Skeddle III, 989 F. Supp. at 919.


the court explained the subject matter test as follows:

As a general rule, waiver of the privilege with regard to some communications waives the privilege as to all other communications relating to the “same subject matter.” In re Grand Jury Proceedings, 78 F.3d at 255–56; United States v. Mendelsohn, 896 F.2d 1183, 1189 (9th Cir. 1990). This rule seeks to avoid the unfairness that might result from selective disclosure while, at the same time, upholding the privilege and preserving the interests it protects form excessive exposure.

Despite the centrality of the term, “same subject matter,” to this inquiry, courts have not defined its meaning and content precisely. Aside from a general instruction to construe “same subject matter” narrowly, . . . no guidance has been given about how a trial court is to determine what is and what is not within the same subject matter when disclosure of some privileged communications has taken place.

Among the factors which appear to be pertinent in determining whether disclosed and undisclosed communications relate to the same subject matter are: 1) the general nature of the lawyer’s assignment; 2) the extent to which the lawyer’s activities in fulfilling that assignment are undifferentiated and unitary or are distinct and severable; 3) the extent to which the disclosed and undisclosed communications share, or do not share, a common nexus with a distinct activity; 4) the circumstances in and purposes for which disclosure originally was made; 5) the circumstances in and purposes for which further disclosure is sought; 6) the risks to the interests protected by the privilege if further disclosure were to occur; and 7) the prejudice which might result if disclosure were not to occur. By applying these factors, and such other factors as may appear appropriate, a court may be able to comply with the mandate that it construe “same subject matter” narrowly while accommodating fundamental fairness.744

The Skeddle court then applied these factors to the specifics of the general counsel’s testimony. While the general counsel did testify regarding telephone conversations and meetings with certain corporate officers and other facts acquired during the general counsel’s investigation into the scheme, the court concluded that the subject of the general counsel’s limited testimony could not be found to cover the entire investigative file of the corporation, finding that the testimony referred to only a small portion of the general counsel’s activities for the corporation, activities consisting of distinct and severable activities, all self-contained and unitary in focus.745 The court further stated that the testimony did not have a common nexus with every other attorney-client communication in the corporation’s investigative file, and that to use the limited, factual disclosures as a bootstrap to discover the entire investigative file would run counter to the principles underlying the narrow waiver of the attorney-client

744 Skeddle I, 989 F. Supp. at 908–09. 745 Skeddle III, 989 F. Supp. at 920.


privilege.746

The Skeddle court even found that the disclosure of documents which made references to discussions that were otherwise privileged did not waive privilege as to those discussions, finding that the referenced discussions related to a subject distinct from the subject of the documents disclosed.747 The court noted the jeopardy in which privileged documents would be placed if partial disclosure waived privilege as to the entire matter, stating:

If . . . disclosure of the notes exposed every otherwise privileged communication as to the matters referenced . . . , the privilege would be withdrawn from dozens, if not hundreds of communications as to which all participants had expected confidentiality. Interests protected by the privilege would be placed in great jeopardy if the subject matter of the . . . notes were deemed to be every topic mentioned in those notes.748

One document addressed in this opinion is of particular relevance. A letter from the corporation’s outside counsel to an attorney for liability insurers of corporate directors and officers, which set forth the corporation’s basis for an insurance claim arising from the defendants’ alleged misconduct, was disclosed at trial.749 While the letter itself was found not privileged, the court found privileged the communications which underlay the conclusions of the letter because allowing such disclosure would undermine substantially, if not completely, the purpose of the attorney-client privilege.750 The court stated that, “requiring such disclosure would permit discovery of underlying privileged communications whenever an attorney states an opinion based on such communications. Such broad waiver runs counter to the protection generally afforded to attorney-client relationship.”751

In light of the potential danger of a broad scale waiver of attorney-client privilege under the subject matter test, counsel should be particularly attentive to opportunities to stress the confidential nature of attorney-client communications with the officers and representatives of their clients. When disclosing information that may be privileged, counsel may endeavor to limit the scope of any waiver by stating in writing that no waiver of the attorney-client privilege is intended thereby.

In one unreported case, a corporation avoided waiving the attorney-client privilege in certain documents, and as to all other documents covering the same subject matter, by

746 Id. 747 Skeddle I, 989 F. Supp. at 911. A close examination of this series of opinions illustrates the court’s effort to

find the undisclosed statements privileged. For example, relating to one particular document, the court found that the subject matter of the document was the author’s understanding of the significance of certain events rather than being the subject matter of the events themselves. See In re Carbo Ceramics, Inc., in which the court focused on particular documents as to which the privilege was waived and rejected claims that all other documents on a privilege log lost their privilege as a result of a waiver as to other documents. 81 S.W.3d 369, 378–79 (Tex.App.—Houston [14th Dist.] 2002, pet. granted in part and denied in part).

748 Skeddle I, 989 F. Supp. at 911. 749 Id. 750 Id. at 911–12. 751 Id. at 912.


specifically not waiving the attorney-client privilege in the process of disclosing the documents:

Ernst & Young next claims that ShareAmerica’s “disclosure of communications with and among attorneys from K & L regarding the SEC’s inquiry and the planned public offering constitutes a waiver of the attorney-client and work product privileges with respect to those documents and all other documents covering the same subject matter.” (Defendant’s brief dated 5/30/97 at p. 13.) ShareAmerica, however, has submitted an affidavit from Attorney Daniel Shepro that shows the document production and testimony occurred without a waiver of ShareAmerica’s privileges. . . . The motion to compel is denied.752

10. Federal Rule of Evidence 502 Limiting Waiver of Privileges

On September 19, 2008, Senate Bill 2450 was signed into law, amending the Federal Rules of Evidence to add Rule 502 which limits the circumstances under which a disclosure of information (particularly one that is inadvertent) results in a waiver of the attorney-client or work-product privilege. Rule 502 applies in all proceedings commenced after the date of enactment (September 19, 2008) and, insofar as is just and practicable, in all proceedings pending on that date.753

New Rule 502 addresses the issue of subject matter waiver by providing that when a disclosure is made in a federal proceeding (or to a federal office or agency) and waives the attorney-client or work-product privilege, that waiver will extend to undisclosed materials in a state or federal proceeding only if the waiver is intentional and the disclosed and undisclosed materials concern the same subject matter and ought in fairness to be considered together.754 Rule 502 also addresses inadvertent disclosures by providing that when a disclosure is made in a federal proceeding (or to a federal office or agency), the disclosure will not operate as a waiver in a federal or state proceeding if the disclosure is inadvertent and the holder of the privilege took reasonable steps to prevent the disclosure and promptly took reasonable steps to rectify the error.755

An addendum to the explanatory note in the Congressional Record accompanying Rule 502 cautions that Rule 502 “does not provide a basis for a court to enable parties to agree to a selective waiver of the privilege, such as to a federal agency conducting an investigation, while preserving the privilege as against other parties seeking the information.”756

752 ShareAmerica, Inc. v. Ernst & Young, No. 933071325, 1998 WL 90731, at *3 (Conn. Super. Feb 20, 1998)

(not reported in A.2d) (emphasis added). 753 154 CONG. REC. H7817 (daily ed. Sept. 8, 2008). 754 Id. 755 Id. 756 Id. at H7818-19.


11. Exceptions to the Privilege

The Texas Rules of Evidence recognize the following five exceptions to the attorney-client privilege:

(1) Furtherance of Crime or Fraud. If the services of the lawyer were sought or obtained to enable or aid anyone to commit or further continuing or future criminal or fraudulent activity, as contrasted with advice regarding prior wrong doing;757

(2) Claimants Through Same Deceased Client. As to a communication relevant to an issue between parties who claim through the same deceased client, regardless of whether the claims are by testate or intestate succession or by inter vivos transactions;

(3) Breach of Duty by a Lawyer or Client. As to a communication relevant to an issue of breach of duty by a lawyer to the client or by a client to the lawyer;

(4) Document Attested by a Lawyer. As to a communication relevant to an issue concerning an attested document to which the lawyer is an attesting witness; or

(5) Joint Clients. As to a communication relevant to a matter of common interest between or among two or more clients if the communication was made by any of them to a lawyer retained or consulted in common, when offered in an action between or among any of the clients.758

In contrast to other aspects of the attorney-client privilege, the exceptions are relatively straightforward and have yielded remarkably little litigation. Of the five, the crime/fraud exception has resulted in the most controversy in terms of its applicability. The U.S. Supreme Court has explained that the “privilege takes flight if the relation is abused. A client who consults an attorney for advice that will serve him in the commission of a fraud will have no help from the law. He must let the truth be told.”759

Some plaintiffs have tried to pierce the attorney-client privilege by simply asserting a fraud cause of action and then arguing that the crime/fraud exception applies to all legal advice the adverse party received. This tactic has been rejected, with courts holding that the plaintiff must first prove a prima facie case of fraud and then show that the attorney-client

757 In re Grand Jury Subpoena, 419 F.3d 329 (5th Cir. 2005) (finding crime-fraud exception does not extend to

all communications made in the course of the attorney-client relationship, but rather is limited to those communications and documents in furtherance of the contemplated or ongoing criminal or fraudulent conduct and does not apply to advice regarding prior wrongful acts).

758 TEX. R. EVID. 503(d). 759 Clark v. United States, 289 U.S. 1, 15 (1933).


communication was in furtherance of the fraud in order to commit the fraud.760 Key to the application of the crime/fraud exception is the timing of the communication. In order for the exception to apply, it is usually necessary for the communication to have been made in contemplation of the fraud761 and either before or during the commission of the fraud.762 Recently, several courts have applied the exception in situations where the attorney’s advice was alleged to have assisted in covering up the fraud.763

C. Work Product Doctrine

The work product privilege764 is a common law doctrine now codified in the federal and state rules of civil procedure that protects the privacy of an attorney’s trial preparations, and may protect an attorney’s work product from discovery by opposing counsel where the attorney-client privilege is not available. Generally, the work product privilege only protects from unwarranted disclosure materials prepared by an attorney, or under an attorney’s direction, “in anticipation of litigation or for trial.”765 Therefore, in absence of any anticipated or pending litigation,766 documents prepared for the purposes of a specific business transaction

760 Cigna Corp. v. Spears, 838 S.W.2d 561, 569 (Tex. App.—San Antonio 1992, no writ). 761 Arkla, Inc. v. Harris, 846 S.W.2d 623, 630 (Tex. App.—Houston [14th Dist.] 1993, orig. proceeding). 762 Freeman v. Bianchi, 820 S.W.2d 853, 861–62 (Tex. App.—Houston [1st. Dist.] 1991, writ granted on

condition); Granada Corp. v. First Court of Appeals, 844 S.W.2d 223, 225 (Tex. 1992, writ denied). 763 See, e.g., American Tobacco Co. v. Florida, 697 So.2d 1249 (Fla. Dist. Ct. App. 4th Dist. 1997); In re A. H.

Robins Co., Inc., 107 F.R.D. 2 (D. Kan. 1985). 764 Some courts prefer to use the term “doctrine” rather than “privilege” because of the more limited protection

given to work product in certain situations. See Westinghouse Elec. Corp. v. Philippines, 951 F.2d 1414, 1417 n.1 (3d Cir. 1991).

765 See FED. R. CIV. P. 26(b)(3); TEX. R. CIV. P. 192.5(a)(1). 766 See McCoo v. Denny’s, Inc., 192 F.R.D. 675, 683 (D. Kan. 2000) (noting “[t]he inchoate possibility, or even

likely chance, of litigation does not give rise to the privilege”); Garrett v. Metropolitan Life Ins. Co., No. 95 Civ. 2406, 1996 WL 325725 at *3 (S.D.N.Y. June 12, 1996) (noting that investigations by regulatory agencies may present “more than a mere possibility of future litigation, and provide reasonable grounds for anticipating litigation”). In U.S. v. Textron, Inc., the court acknowledged a current split in the circuits regarding the definition of “anticipation of litigation.” No. 07-2631, 2009 WL 136752, at *10 (1st Cir. 2009). The two tests causing the split among the circuits are the “because of” test and the “primary purpose” test. The court in Textron applied the “because of” test which provides that a document is prepared in anticipation of litigation if “the document[] would not have been prepared irrespective of the prospect of litigation . . . .” Id. at 6. Upon application of the “because of” test, the court in Textron held that Textron’s tax accrual workpapers were prepared in anticipation of litigation. In so holding, the court rejected “the IRS’s contention that the mere presence of a business or regulatory purpose defeats work-product protection.” Id. at 7. The IRS argued that since the tax accrual workpapers were created both for the business purpose of obtaining a “‘clean’ opinion” from Textron’s independent auditor and the regulatory purpose of complying with reporting and securities obligations, the workpapers did not qualify for work-product protection. Id. The IRS based its argument on the text of the Advisory Committee’s commentary on Rule 26: “Materials assembled in the ordinary course of business, or pursuant to public requirements unrelated to litigation, or for other nonlitigation purposes are not under the qualified immunity provided by this subsection.” FED. R. EVID 26(b)(3) advisory committee’s note. The court acknowledged that documents prepared in the ordinary course of business “rather than for purposes of litigation” are afforded no work-product protection, but noted that “‘[d]ual purpose’ documents created because of the prospect of litigation are protected even though they were also prepared for a business purpose.” Textron, 2009 WL 136752, at *7 (quoting 8 CHARLES ALAN WRIGHT, ARTHUR R. MILLER & RICHARD L. MARCUS, FEDERAL PRACTICE AND

PROCEDURE §2024 (2008). The “primary purpose” test, as adopted by the Fifth Circuit, provides that a document is


are not protected by the work product doctrine.767

The work product doctrine was first recognized by the U. S. Supreme Court in Hickman v. Taylor768 wherein, finding no existing privilege that applied, the Court created a new common law privilege for what it termed the “work product of the lawyer,” consisting of interviews, memoranda, briefs and other materials prepared “with an eye toward litigation.”769 The Court justified the privilege as follows:

Proper preparation of a client’s case demands that [the attorney] assemble information, sift what he considers to be the relevant from the irrelevant facts, prepare his legal theories and plan his strategy without undue and needless interference. That is the historical and the necessary way in which lawyers act within the framework of our system of jurisprudence to promote justice and to protect their clients’ interests.770

The Court indicated that the privilege could be overcome as to factual information otherwise unavailable to the opposing party, but not as to the attorney’s “mental impressions.”771

The Hickman work product doctrine was codified in Rule 26(b)(3) of the Federal Rules of Civil Procedure in 1970, which extends protection to the work of a party’s representatives, “including an attorney, consultant, surety, indemnitor, insurer, or agent” in anticipation of litigation or for trial. The rule maintains the distinction between ordinary work product, which is discoverable upon a showing of “substantial need” and “undue hardship,” and an attorney’s “mental impressions, conclusions, opinions, or legal theories,” which are discoverable, if at all, only upon a much higher showing.772 This latter category has come to be known as “opinion”

prepared in anticipation of litigation if the “primary motivating purpose behind the creation of the document was to aid in possible future litigation.” U.S. v. El Paso Co., 682 F.2d 530 (5th Cir. 1982) (quoting U.S. v. Davis, 636 F.2d 1028, 1040 (5th Cir. 1981)).

767 Internal investigation to satisfy auditors or lenders did not have required relationship to litigation, although litigation was looming. In re Royal Ahold N.V. Securities & ERISA Litig., 230 F.R.D. 433 (D. Md. 2006). But see U.S. v. Textron, Inc., No. 07-2631, 2009 WL 136752, at *4-6 (1st Cir. 2009) (holding that the mere presence of a business purpose does not prevent the application of the work product doctrine).

768 329 U.S. 495 (1947). 769 Id. at 511. 770 Id. 771 Id. at 512. 772 The work product doctrine, however, is not an impenetrable barrier, it is a qualified immunity:

It allows a party to seek materials prepared in anticipation of litigation only when the party: 1) has a substantial need for the materials; and 2) the party cannot acquire a substantial equivalent of the materials by other means without undue hardship. Even when such a showing of need and unavailability is made, the rule specifically protects the mental impressions, conclusions, opinions and legal theories of the party’s attorney. This is referred to as opinion work product (as opposed to trial preparations that are merely historical or fact based). Opinion work product is subject to disclosure according to a more stringent standard. A court will protect opinion work product unless the requesting party can show that it is directed to the pivotal issue in the current litigation and the need for the information is compelling.

Saito v. McKesson HBOC, Inc., No. 18553, 2002 Del. Ch. LEXIS 125 at *9 (Del. Ch. Oct. 25, 2002).


or “core” work product.773 Rule 26(b)(3) has been adopted verbatim by 34 states, and in substantial part by 10 others.774 The work product doctrine has been more specifically and comprehensively incorporated into Texas Rules of Civil Procedure,775 which defined “work product”776 consistently with the Federal Rules of Civil Procedure.

Like the attorney-client privilege, the work product privilege is subject to waiver, but the scope of a work product waiver is more limited. Work product protection can be destroyed or waived only by an action that substantially increases the possibility that an adversary in litigation will gain access to the work product documents777 and waiver of work product

773 See In re Murphy, 560 F.2d 326, 329 n.1 (8th Cir. 1977); Jeff A. Anderson et al., Special Project, The Work

Product Doctrine, 68 CORNELL L. REV. 760, 817–20 (1983). 774 See Elizabeth Thornburg, Rethinking Work Product, 77 VA. L. REV. 1515, 1520–21 (1991). 775 See TEX. R. CIV. P. 192.5. The party communication privilege, previously codified separately in the Texas

Rules of Civil Procedure 166b(3)(d), has been incorporated into the work product rule as Rule 192.5(a)(2). The Texas Supreme Court has previously held under old Texas Rules of Civil Procedure 166(3)(d) that the party communications privilege is case specific (i.e. to be privileged, the communication must “occur during or in anticipation of the particular suit in which the privilege is asserted”) in Republic Ins. Co. v. Davis, but this result was based on specific wording of the old rule that is different in new Rule 192.5(a)(2) and should not be the result under the wording of the new rule, which is not case specific. 856 S.W.2d 158, 164–65 (Tex. 1993). In Owens-Corning Fiberglas v. Caldwell, the Texas Supreme Court rejected the argument that the work product privilege applies only in the particular case in which it was generated, writing “we hold that the work product privilege in Texas is of continuing duration.” 818 S.W.2d 749, 751-52 (Tex. 1991).

776 The Texas Rules of Civil Procedure provide:

192.5 Work Product.

(a) Work product defined. Work product comprises:

(1) material prepared or mental impressions developed in anticipation of litigation or for trial by or for a party or a party’s representatives, including the party’s attorneys, consultants, sureties, indemnitors, insurers, or agents; or

(2) a communication made in anticipation of litigation or for trial between a party and the party’s representatives or among a party’s representatives.

(b) Protection of work product.

(1) Protection of core work product -- attorney mental processes. Core work product -- the work product of an attorney or an attorney’s representative that contains the attorney’s or the attorney’s representative’s mental impressions, opinions, conclusions, or legal theories -- is not discoverable.

(2) Protection of other work product. Any other work product is discoverable only upon a showing that the party seeking discovery has substantial need of the materials in the preparation of the party’s case and that the party is unable without undue hardship to obtain the substantial equivalent of the material by other means.

TEX. R. CIV. P. 192.5(a) (1999). 777 In most jurisdictions, a waiver of the work-product protection can occur where the protected communications

are disclosed in a manner which “substantially increases the opportunity for potential adversaries to obtain the information.” See Behnia v. Shapiro, 176 F.R.D. 277, 279 (N.D.Ill. 1997); see also 8 CHARLES ALAN WRIGHT, ARTHUR R. MILLER & RICHARD L. MARCUS, FEDERAL PRACTICE AND PROCEDURE: CIVIL, § 2024, at 369 (1994). The question is whether the particular disclosure was of such a nature as to enable an adversary to gain access to the information. See Behnia, 176 F.R.D. at 279-80; United States v. Amer. Tel. & Tel., 642 F.2d 1285, 1299 (D.C.Cir.


protection by sharing the work product with one adversary can result in waiver as to other unrelated adversaries.778 For example, waiver will not result from disclosing work product information to a non-adversarial party with a common interest.779 Disclosure under a confidentiality agreement militates against a finding of waiver, for it is evidence the party took steps to insure that its work product did not land in the hands of its adversaries.780 Widespread disclosure, however, might prompt a court to find waiver from substantially increasing the probability that privileged information will fall into the hands of an adversary.781 Disclosing work product documents to a government body, particularly where the government is an adversary, can result in privilege waiver.782

1980); United States v. Gulf Oil Corp., 760 F.2d 292, 295 (Temp. Emer. Ct. App. 1985); In re Grand Jury Subpoenas, 561 F. Supp. 1247, 1257 (E.D.N.Y. 1982). In United States v. Textron, Inc., the issue was whether the disclosure of tax accrual workpapers to Textron’s independent auditor waived the protection afforded by the work product doctrine. No. 07-2631, 2009 WL 136752, at *4-6 (1st Cir. 2009). The IRS argued that Textron and its independent auditor were “potential adversaries” citing another First Circuit decision in which M.I.T. (in its capacity as a government contractor) and defense contract auditing agency were deemed to be the same. United States v. M.I.T., 129 F.3d 681, 687 (1st Cir. 1997). In M.I.T. the auditing agency was auditing M.I.T.’s expenses for the purpose of determining whether any expenses should be challenged by the Department of Defense. Id. The court reasoned that the facts were different in the case before them due to the fact that the independent auditor here was “not auditing Textron in order to identify disputes it would have with Textron, but rather, to decide if it could issue a letter certifying Textron’s financial statements. . . .” The court held that Textron did not waive work product protection by disclosing its tax accrual workpapers to its independent auditor, but remanding on the issue of whether the independent auditor’s workpapers were independently discoverable. In a minority of jurisdictions, the waiver of work product protection depends on whether the parties share a common legal interest. In such jurisdictions, the courts will apply the same analysis as for the waiver of attorney-client privilege. See In re Grand Jury Subpoenas 89-3 v. United States, 902 F.2d 244, 248 (4th Cir. 1990); . 778 See In re Stone Energy Corporation, No. 05-2088, 2008 WL 4868086 (W.D. La. Nov. 4, 2008) (Plaintiff in securities fraud class action was not entitled to review attorney internal investigation report prepared for audit committee in anticipation of litigation because the court deemed it to “constitute opinion work product which require[s] an almost absolute protection under Hickman v. Taylor” despite the fact that the defendant company provided it to SEC which was held to be adversary.).

779 Gulf Oil, 760 F.2d at 296; In re Grand Jury Subpoenas, 561 F. Supp. at 1257. 780 Blanchard v. EdgeMark Fin. Corp., 192 F.R.D., 233, 237 (N.D.Ill. 2000). 781 Id. 782 See Westinghouse Elec. Corp. v. Philippines, 951 F.2d 1414, 1423–31 (3d Cir. 1991); In re Subpoenas Duces

Tecum, 738 F.2d 1367, 1369–75 (D.C. Cir. 1984); United States v. Jones, 696 F.2d 1069, 1072 (4th Cir. 1982); but see Diversified Indus., Inc. v. Meredith, 572 F.2d 596, 611 (8th Cir. 1977) (noting voluntary disclosure to a government agency waives the privilege only for the purpose of litigation against that government agency) and Teachers Ins. and Annuity Ass’n v. Shamrock Broad. Co., 521 F. Supp. 638, 644–45 (S.D.N.Y. 1981) (noting disclosure waives the privilege only for the purpose of litigation against the agency if the disclosing party expressly reserves the privilege; otherwise, complete waiver occurs). The forum in which the waiver issue is adjudicated can be outcome determinative. Compare McKesson Corp. v. Green, 610 S.E.2d 54 (Ga. 2005) (holding that the voluntary production of a 180-page internal investigation report by PricewaterhouseCoopers and Skadden, Arps to the SEC and the U.S. Attorney’s Office resulted in a waiver of the work product privilege as they were actual or potential adversaries and the confidentiality agreement allowed the SEC to give the documents to others if it deemed such to be “in furtherance of the [SEC’s] discharge of its duties and responsibilities”), with Saito v. McKesson HBOC, Inc., in which the Delaware Chancery Court adopted a “selective waiver” doctrine that allowed disclosures to the SEC pursuant to a confidentiality agreement without waiver of the work product protection, vis a vis private litigants, reasoning as follows:

As with any privilege, the protection of work product may be waived when it no longer serves its


D. Legal Fee Audits

Insurers routinely audit bills from outside defense counsel to measure compliance with billing guidelines and reduce costs. Disclosure of itemized billings to outside auditors may

useful purpose. The purpose behind the protection of work product is “to promote the adversary system by safeguarding the fruits of an attorney’s trial preparations from the discovery attempts of the opponent. . . . ” Thus, the focus of the doctrine is upon preventing discovery of the work product from an “opposing party in litigation, not necessarily from the rest of the world generally. . . .” There is no waiver of privileged information to third parties if a disclosing party had a reasonable expectancy of privacy when it made an earlier disclosure. . . . Disclosures to a third party do not waive attorney work product when the disclosing party and its recipient share some common interest. . . . The common interest question here boils down to whether the SEC acts as a friend or foe when it begins investigating a company for potential violations of the Securities Act. I think the more reasonable conclusion is that the SEC was a foe in this instance.

. . .

The Delaware Supreme Court has already determined that it is sometimes unfair to allow for partial waivers of work product. No Delaware court, however, has decided whether to allow selective waivers of work product. Selective waiver is the type of waiver at issue in this case, as McKesson HBOC has selectively disclosed its work product to the SEC and now asserts its work product privilege as to these same documents when requested by plaintiff Saito.

. . .

When attorneys secure a confidentiality agreement before sharing their work product with the SEC, as McKesson HBOC’s attorneys did, those attorneys can reasonably assume that the SEC would not reveal those confidential disclosures to other adversaries.

Although it can be argued that McKesson HBOC should not have had an expectation of privacy because some other courts have decided, that such disclosures waive work product privilege, the courts of Delaware have not considered the issue. In fact, plaintiff, defendant, and the SEC alike fight this battle in this Court using weaponry borrowed almost exclusively from foreign jurisdictional battlefields because Delaware’s terrain is barren. The vigorousness of this clashing of swords suggests that the matter is far from settled even on foreign soil.

The resulting decisions cover the entire spectrum—from protection of work product in the absence of a confidentiality agreement to no protection of work product even when a disclosure was secured by a confidentiality agreement. The Eighth Circuit first established the selective waiver doctrine and protected work product disclosures made to the SEC during a private, nonpublic investigation, even without a confidentiality agreement in place. The D.C. Circuit has since found that work product privilege could only be preserved if a confidentiality agreement is in place before the disclosure. The Second, Third, Fourth, and Sixth Circuits have found that waiver of the privilege as to one opponent waives the privilege as to all when there is no confidentiality agreement in place. Of these, some indicated that a confidentiality agreement may have changed the outcome of their decision. Only two cases cited to this Court found that the privilege was waived even when the disclosure was subject to a confidentiality agreement. Therefore, in light of conflicting but non-binding precedent, McKesson HBOC acted reasonably in expecting that its disclosures to the SEC under a confidentiality agreement would not reach the hands of its other adversaries.

. . .

Thus, because I find that it is in the best interests of the shareholders to encourage corporate compliance, and because the law enforcement agencies are designed by our legislature as the first line of defense for such shareholders, I adopt a selective waiver rule for disclosures made to law enforcement agencies pursuant to a confidentiality agreement. Confidential disclosure of work product during law enforcement agency investigations relinquishes the work product privilege only as to that agency, not as to the client's other adversaries. The selective waiver rule encourages cooperation with law enforcement agencies without any negative cost to society or to private plaintiffs.

No. 18553, 2002 WL 31657622 at *3–11 (Del. Ch. Nov. 13, 2002).


waive the attorney-client privilege for the documents disclosed.783 Under the subject matter standard discussed above under “Scope of Waiver,” the waiver might (but should not) be extended beyond the bills themselves to the items referred to therein.

Issues have been raised in ethics opinions in a number of states regarding the propriety of an attorney’s submission of legal bills for outside audit review. The typical conclusion is that law firms may submit their bills directly to an audit company after an informed consent is obtained from the client.784

E. Mergers and Acquisitions

One of the more troublesome problems related to the disclosure of confidential information in the context of negotiating a business combination is how to disclose information to facilitate a meaningful evaluation of litigation-related confidential information without waiving any work-product protections, attorney-client privileges, and similar protections and privileges. The issue can arise either prior to or after closing of a proposed transaction. In an attempt to allow the seller to furnish to the buyer confidential information without waiving the seller’s work product, attorney-client privilege and similar protections by demonstrating that the buyer and seller have or should be presumed to have common legal and commercial interests, or are or may become joint defendants in litigation, Section 12.6 of the ABA Model Asset Purchase Agreement with Commentary (2001) provides:

12.6 ATTORNEY-CLIENT PRIVILEGE.

The Disclosing Party is not waiving, and will not be deemed to have waived or diminished, any of its attorney work product protections, attorney-client privileges, or similar protections and privileges as a result of disclosing its Confidential Information (including Confidential Information related to pending or threatened litigation) to the Receiving Party, regardless of whether the Disclosing Party has asserted, or is or may be entitled to assert, such privileges and protections. The parties (a) share a common legal and commercial interest in all of the Disclosing Party’s Confidential Information that is subject to such privileges and protections, (b) are or may become joint defendants in Proceedings to which the Disclosing Party’s Confidential Information covered by such protections and privileges relates, (c) intend that such privileges and protections remain intact should either party become subject to any actual or threatened Proceeding to which the Disclosing Party’s Confidential Information covered by such protections and privileges relates, and (d) intend that after the

783 See United States v. Mass. Inst. of Tech., 129 F.3d 681 (1st Cir. 1997). 784 K. Hansen & L. Marema, Confidentiality Issue Sparks Controversy, BEST’S REVIEW ‘77 (Feb. 1999). See

Tex. Comm. on Prof’l Ethics, Formal Op. 552 (2004) (opining that a lawyer’s fee statement or invoice is confidential information which the lawyer must protect under Rule 1.05 of the Texas Disciplinary Rules of Professional Conduct and that a lawyer who has been retained by an insurance company to defend its insured cannot disclose the lawyer’s fee statement to the insurance company’s third party auditor absent consent of the client after consultation (consent in advance through a policy provision is not sufficient consent since it is by definition not made after consultation with the client)).


Closing the Receiving Party shall have the right to assert such protections and privileges. No Receiving Party shall admit, claim or contend, in Proceedings involving either party or otherwise, that any Disclosing Party waived any of its attorney work product protections, attorney-client privileges, or similar protections and privileges with respect to any information, documents or other material not disclosed to a Receiving Party due to the Disclosing Party disclosing its Confidential Information (including Confidential Information related to pending or threatened litigation) to the Receiving Party.

There may be instances when the receiving party is an actual or potentially adverse party in litigation with the disclosing party (e.g., when litigation is the driving force behind an acquisition). In those cases, the language of Section 12.6 is intended to bolster a claim by the disclosing party that the recipient is later precluded from using disclosure as a basis for asserting that the privilege was waived.

Whether work product protections and attorney-client privileges will be deemed to be waived as a result of disclosures in connection with a consummated or unconsummated asset purchase depends on the law applied by the forum jurisdiction and the forum jurisdiction’s approach to the joint defendant and common interest doctrines. In most jurisdictions, work product protection will be waived only if the party discloses the protected documents in a manner which substantially increases the opportunities for its potential adversaries to obtain the information. By contrast, the attorney-client privilege will be waived as a result of voluntary disclosure to any third party, unless the forum jurisdiction applies a form of the joint defense or common interest doctrines.

Although the consummation of a transaction is not determinative of the existence of a waiver, the interests of the parties may become closely aligned as a result of the closing. As a result, there is a higher probability that information will remain protected in a transaction that closes, and in which the buyer assumes liability for the seller’s litigation, than in a transaction that does not close and in which the buyer does not assume liability for the seller’s litigation.785 Generally, (i) in a statutory merger the surviving corporation can assert the attorney-client privilege, (ii) in a stock-for-stock deal the privilege goes with the corporation, although in some cases the buyer and seller may share the privilege, and (iii) in the case of an asset sale some cases hold no privilege passes because the corporate holder of the privilege has not been sold786 while others hold that a transfer of all of sellers right, title and interest in the assets of a business effectively transfers the right to assert or waive the privilege.787 In an asset sale,

785 See Hundley, White Knights, Pre-Nuptial Confidences, and the Morning After: The Effect of Transaction-Related Disclosures on the Attorney-Client and Related Privileges, 5 DEPAUL BUS. L.J. 59 (Fall/Winter, 1992/1993); cf. Cheeves v. Southern Clays, Inc., 128 F.R.D. 128, 130 (M.D. Ga. 1989) (noting “courts have found a community of interest where one party owes a duty to defend another, or where both consult the same attorney.”).

786 Cheeves, 128 F.R.D. at 130 (M.D. Ga. 1989); In re Cap Rock Elec. Coop., Inc., 35 S.W.3d 222 (Tex. App.—Texarkana 2000, no pet.).

787 Louisiana Municipal Police Employees’ Retirement System v. Sealed Air Corp., Fed. Sec. L. Rep. (CCH) ¶94,807 (D. N.J. August 11, 2008) (In rejecting plaintiff’s assertion of both attorney work product and attorney-client privilege waivers because buyer and seller were on opposite sides of a negotiated transaction, the Court wrote, “The weight of case law suggests that, as a general matter, privileged information exchanged during a merger between two


including a sale of a division, the parties could provide contractually for the buyer to have the benefit of the privilege, as Section 12.6 does, and, by analogy to joint defense and common interest cases, the privilege agreement should be upheld.788 Further, by analogy to those cases and the principle that the privilege attaches to communications between an attorney and prospective client prior to engagement, parties should be able to provide that due diligence information provided is protected by the attorney-client privilege.789

Courts may also maintain the attorney-client privilege when the interests of both parties are aligned through specific contractual relationships.790 Therefore, the parties may find some comfort in provisions that align their legal interests and burdens, such as provisions pursuant to which buyer assumes the litigation liability of seller, indemnification provisions or assistance provisions which may facilitate a court’s application of the common interest doctrine. If

unaffiliated business would fall within the common-interest doctrine,” quoting from Cavallaro v. United States, 153 F. Supp. 2d 52, 61 (D. Mass. 2001), aff’d on other grounds 284 F.3d 236 (1st Cir. 2002), and citing Rayman v. Am. Charter Fed. Sav. & Loan Ass’n, 148 F.R.D. 647, 655 (D. Neb. 1993)); Coffin v. Bowater Incorporated, No. 03-227-P-C, 2005 U.S. Dist. LEXIS 9395 (D. Me. May 13, 2005); Soverain Software LLC v. Gap, Inc., 340 F. Supp. 2d 760 (E.D. Tex. 2004); Cheeves v. Southern Clays, 128 F.R.D. 128, 130 (M.D. Ga. 1989); In re Cap Rock Elec. Coop., Inc., 35 S.W.3d 222 (Tex. App.—Texarkana 2000); see Subcommittee on Recent Judicial Developments, ABA Negotiated Acquisitions Committee, Annual Survey of Judicial Developments Pertaining to Mergers and Acquisitions, 61 BUS. LAW. 1007, 1007-09 (2006). In Tekni-Plex, Inc. v. Meyner and Landis, 89 N.Y.2d 123, 674 N.E. 2d 663 (1996), the New York Court of Appeals held that in a triangular merger the purchaser could not preclude long-time counsel for the seller and its sole shareholder from representing the shareholder in an indemnification claim arising out of the merger, and that the purchaser controlled the attorney-client privilege as to pre-merger communications with the seller, other than those relating to the merger negotiations. Responding to an argument that the transaction was really an asset acquisition, the Court said in dictum: “When ownership of a corporation changes hands, whether the attorney-client relationship transfers . . . to the new owners turns on the practical consequences rather than the formalities of the particular transaction.” Id. at 133. Postorivo v. AG Paintball Holdings, Inc., Nos. 2991-VCP, 3111-VCP, 2008 WL 343856 (Del. Ch. 2008), arose in the context of a contract indemnity action brought by the buyer under an asset purchase agreement against the seller over seller’s representations, warranties and covenants. The Delaware Chancery Court (applying New York law and relying on Tekni-Plex, Inc. v. Meyner & Landis, supra) held that, under the asset purchase agreement, the seller retained the attorney-client privilege with respect to communications regarding the excluded assets and liabilities. The Court confirmed the agreement of the parties that buyer holds the attorney-client privilege with respect to communications regarding the operation of the business before and after the asset purchase agreement, and seller holds the privilege as to communications regarding the negotiation of the asset purchase agreement. In so holding, the Court cited with approval the Tekni-Plex approach that practical consequences trump the form of the transaction, and rejected buyer’s argument that the attorney-client privilege is “an incident of control and cannot be split among several different entities, even if a written contract among the parties provides to the contrary.”

788 See Subcommittee on Recent Judicial Developments, ABA Negotiated Acquisitions Committee, Annual Survey of Judicial Developments Pertaining to Mergers and Acquisitions, 60 BUS. LAW. 843, 861–63 (2005) (discussing Venture Law Group v. Superior Court, 12 Cal. Rptr. 3d 656 (Cal. Ct. App. 2004), which held that the surviving corporation in a merger is the holder of the attorney-client privileges of both constituent corporations post merger and an attorney for the non-surviving corporation has a duty to exercise the privilege unless instructed not to do so by the surviving corporation).

789 Cap Rock, 35 S.W.3d at 222; cf. Cheeves, 128 F.R.D. at 130 (M.D. Ga. 1989) (“courts have found a community of interest where one party owes a duty to defend another, or where both consult the same attorney”).

790 See In re Regents of Univ. of Cal., 101 F.3d 1386, 1390 (Fed. Cir. 1996) (holding that parties to an exclusive license agreement have a substantially identical legal interest).


appropriate, the parties also should consider signing a “common interest agreement” or a “joint defense plan” that evidences their common legal interests and stipulates a common plan for litigation.


EXHIBIT B:FORM OF OUTSIDE LAW FIRM RESPONSE LETTER

Re: ______________ (the “Company”, such term to refer also to the subsidiaries or other

related entities, if any, listed in Annex A hereto)

Gentlemen:

By letter dated ____________ (the “Inquiry Letter”), ____________, requested that we furnish you certain information in connection with your examination of the accounts of the Company as of ____________ (the “Examination Date”) and for the year then ended. Accordingly, subject to the qualifications and limitations set forth below, we advise you that as of ____________, which is the date our internal review procedure for purposes of preparing this letter was commenced (the “Review Date”), we were not engaged on behalf of the Company in giving substantive legal attention to, or representing the Company in connection with, any Loss Contingency, except as set forth in Annex B hereto. As used herein, “Loss Contingency” means: (i) any overtly threatened or pending litigation (as defined in the ABA Statement of Policy referred to below) which we have recognized as involving a potential loss to the Company of ____________ or more, (ii) any contractually assumed obligation, if any, which the Company has, in the Inquiry Letter, specifically identified and requested that we comment on herein, and (iii) any unasserted possible claim or assessment, if any, which the Company has, in the Inquiry Letter, specifically identified and requested that we comment on herein.

This response is limited by, and is in accordance with, the ABA Statement of Policy Regarding Lawyers’ Responses to Auditors’ Requests for Information (December, 1975) and the accompanying Commentary (collectively, the “ABA Statement of Policy”). We are not responding to any request, nor are we commenting on any statement, contained in the Inquiry Letter which we believe to be inconsistent with the intent of the ABA Statement of Policy. No inference should be drawn from our failure to respond to or comment on any such request or statement.

The information set forth in this response is current as of the Review Date, except as otherwise noted, and we disclaim any undertaking or obligation to advise you of any changes which thereafter may have been or may be brought to our attention.

In connection with the preparation of this response, we have made no examination of the records or files of the Company, nor have we reviewed any of the transactions or contractual arrangements of the Company or interviewed any of the officers or employees of the Company, or made any other investigation of the Company whatsoever. On the contrary, our procedures in the preparation of this response have been limited to an endeavor to determine from lawyers presently in our Firm who, on behalf of the Firm, have performed services for the Company since ____________ whether such services involved substantive attention in the


form of legal consultation or legal representation (as distinguished from general legal advice) concerning any Loss Contingency of the nature described in clause (i) of the definition of such term in the first paragraph of this letter existing as of the dates referred to in the second sentence of such first paragraph.

Consistent with the last sentence of paragraph 6 of the ABA Statement of Policy and pursuant to the Company’s request, this will confirm as correct the Company’s understanding as set forth in the Company’s inquiry letter to us that whenever, in the course of performing legal services for the Company on specific matters which we have recognized as involving an unasserted possible claim or assessment that may call for financial statement disclosure, we have formed a professional conclusion that the Company must disclose or consider disclosure concerning such possible claim or assessment we, as a matter of professional responsibility to the Company, will endeavor to so advise the Company and, if requested to do so, will consult with the Company concerning the question of such disclosure and the applicable requirements of Statement of Financial Accounting Standards No. 5. You are further advised, however, that we have not been engaged by the Company for the specific purpose of providing advice and consultation concerning questions of financial disclosure. Accordingly, and in view of the limited extent to which we have represented the Company and our limited knowledge of the Company’s affairs and the requirements for financial statement disclosures applicable to the Company, it is unlikely that we would form any professional conclusions concerning such disclosures. Furthermore, while we will so consult with the Company, we will not ordinarily make an independent investigation of facts furnished to us by the Company. Also, in the course of such consultation we will not ordinarily reach and express a professional conclusion that the Company must disclose a discrete matter or that the ultimate decision which the Company may make is either correct or incorrect. We are not commenting on the accuracy or completeness of any specification, or lack of specification, made by the Company in the Inquiry Letter in respect of unasserted possible claims or assessments or any advice, or lack of advice, we may have given the Company with respect to any such claims or assessments.

It is our understanding that the Company, by making the request set forth in the Inquiry Letter, does not intend to waive the attorney-client privilege with respect to any information which the Company has furnished to us. Moreover, please be advised that this response should not be construed in any way to constitute a waiver of the attorney-work product privilege with respect to any of our files involving the Company.

Please refer to Annexes A and B hereto for certain other information relating to this response letter.


This letter is solely for your information and assistance in connection with your audit of the financial condition of the Company as of the Examination Date and is not to be quoted or otherwise referred to in any financial statement of the Company or related documents nor is it to be filed with or furnished to any governmental agency or any other person without the prior written consent of this Firm.

Very truly yours,

[Law Firm Name]

By________________________________


ANNEX A:MISCELLANEOUS MATTERS

1. List of Subsidiaries or Other Related Entities

List all subsidiaries or other related entities, if any, named in the Inquiry Letter. Make certain that each subsidiary or other related entity named in the Inquiry Letter was similarly named in the related Firm information request form. If no subsidiaries or other related entities are named in the Inquiry Letter, insert the word NONE.

[LIST SUBSIDIARIES HERE]

2. Scope of Engagement

Insert one of the following paragraphs or an appropriate variation thereof:

While we represent the Company on a regular basis, we are not undertaking to comment on whether the Company is involved in legal matters for which we have no responsibility or on matters in respect of which we may have rendered general legal advice to the Company.

While we represent the Company (or certain of the subsidiaries or other entities included within the meaning of “Company” herein) on a regular basis, the Company, as you are aware, engages other counsel from time to time with respect to various legal matters. We are not undertaking to comment on whether the Company is involved in legal matters for which we have no responsibility or on matters in respect of which we may have rendered general legal advice to the Company.

We do not represent the Company generally and our representation of the Company is limited to matters for which we are specifically engaged as its counsel. We are not undertaking to comment on whether the Company is involved in legal matters for which we have no responsibility.

3. Other Matters

(a) If requested by the Inquiry Letter, insert one of the following paragraphs or an appropriate variation thereof:

Our records reflect that as of ____________, there was ____________ and ____________, respectively, owing to us by the Company for services and disbursements previously billed. It is not our practice to quote unbilled expenses and estimated fees.

Our records reflect that as of ____________, there was no amount owing to us by the Company for services and disbursements previously billed. It is not our practice to quote unbilled expenses and estimated fees.

Our records reflect that as of ____________, there was ____________ owing to us by the Company for services and disbursements previously billed and that as of the date hereof no amount is owed to us by the Company for services and disbursements previously billed. It is


not our practice to quote unbilled expenses and estimated fees.

Our records reflect that as of ____________ no amount was owing to us by the Company for services and disbursements previously billed and that as of the date hereof ____________ is owed to us by the Company for services and disbursements previously billed. It is not our practice to quote unbilled expenses and estimated fees.

(b) Insert the following paragraph if appropriate:

____________, an attorney in this Firm, is a Director of the Company. This letter does not purport to encompass information which may have been communicated to such attorney by reason of his serving as a Director.

(c) Insert paragraphs containing other information, if any, which the attorney in charge deems necessary or appropriate. If no paragraphs are being inserted in response to this Item 3, insert the word NONE.


ANNEX B:DESCRIPTION OF LOSS CONTINGENCIES

1. Contractually Assumed Obligations

Describe each Loss Contingency of this type being commented on. Remember that no such Loss Contingency is to be commented on unless it is specifically identified in the Inquiry Letter. See “CAUTION” at the end of this Fill-in Information Sheet.

If no Loss Contingency of this type is specifically identified in the Inquiry Letter, insert the following:

NONE. No contractually assumed obligation was specifically identified in the Inquiry Letter for comment in this response. Accordingly, we are not commenting on any contractually assumed obligations or any representations of the Company in the Inquiry Letter with respect thereto.

2. Unasserted Possible Claims and Assessments

Describe each Loss Contingency of this type being commented on. Remember that no such Loss Contingency is to be commented on unless it is specifically identified in the Inquiry Letter. See “CAUTION” at the end of this Fill-in Information Sheet.

If no Loss Contingency of this type is specifically identified in the Inquiry Letter, insert the following:

NONE. No unasserted claim or assessment was specifically identified in the Inquiry Letter for comment in this response. Accordingly, we are not commenting on any unasserted possible claims or assessments or any representations of the Company in the Inquiry Letter with respect thereto.

3. Overtly Threatened or Pending Litigation

Describe each Loss Contingency of this type being commented on. See “CAUTION” at the end of this Fill-in Information Sheet. If there is no Loss Contingency of this type to be described, insert the word NONE.

(a) Because we have not formed a conclusion as to whether an unfavorable outcome is either probable or remote (as defined in the ABA Statement of Policy), we express no opinion as to the likelihood of an unfavorable outcome or the amount or range of any possible loss to the Company.

CAUTION: BE SURE TO REMOVE THIS INFORMATION BEFORE FINALIZING THE LETTER!!!

The definition of “Loss Contingency” is contained in the first paragraph of the response letter. For this purpose, the attorney preparing the response letter should understand that the ABA Statement of Policy defines “overtly threatened litigation” to


mean “that a potential claimant has manifested to the client an awareness of and present intention to assert a possible claim or assessment unless the likelihood of litigation (or of settlement when litigation would normally be avoided) is considered remote”.

Each Inquiry Letter which we receive from a client attempts, in one way or another, to get us to evaluate, with respect to each Loss Contingency described in our response letter, the likelihood of an unfavorable outcome and to estimate the amount or range of potential loss. Because applicable accounting rules (Statement of Financial Accounting Standards No. 5) use the terms “probable”, “reasonably possible,” and “remote” in describing the process of quantifying the likelihood of an unfavorable outcome, such terms, when used in a response letter, will generally be accorded specific meanings. Therefore, none of these terms should be utilized unless the attorney preparing the response letter intends to convey the specific meaning contemplated by the accounting rules.

The ABA Statement of Policy contains several statements to the effect that, given the uncertainties associated with defending or prosecuting a Loss Contingency, clients (and their auditors) generally should not expect attorneys to render, and attorneys generally will not be in a position to give, any meaningful estimate of the likelihood of an unfavorable outcome or the amount or range of damages. Consider, in this regard, the following excerpts from the ABA Statement of Policy:

In view of the inherent uncertainties, the lawyer should normally refrain from expressing judgments as to outcome except in those relatively few clear cases where it appears to the lawyer that an unfavorable outcome is either ‘probable’ or ‘remote’; for purposes of any such judgment it is appropriate to use the following meanings:

(i) probable—an unfavorable outcome for the client is probable if the prospects of the claimant not succeeding are judged to be extremely doubtful and the prospects for success by the client in its defense are judged to be slight.

(ii) remote—an unfavorable outcome is remote if the prospects for the client not succeeding in its defense are judged to be extremely doubtful and the prospects of success by the claimant are judged to be slight. . . .

[T]he amount or range of potential loss will normally be as inherently impossible to ascertain, with any degree of certainty, as the outcome of the litigation. Therefore, it is appropriate for the lawyer to provide an estimate of the amount or range of potential loss (if the outcome should be unfavorable) only if he believes that the probability of inaccuracy of the estimate of the amount or range of potential loss is slight. . . . In most cases, the lawyer will not be able to provide any such estimate to the auditor.

Essentially, a response letter can properly contain an unqualified evaluation of


probable outcome only in instances where we believe the client would win or lose on summary judgment. If we cannot say that the client would prevail on a summary judgment motion filed by it, then we cannot say that a favorable outcome is probable or that an unfavorable outcome is remote. Moreover, if we cannot say that the client would lose a summary judgment motion filed against it, then we cannot say that a favorable outcome is remote or that an unfavorable outcome is probable.

For the foregoing reasons, Loss Contingency descriptions typically conclude with or otherwise contain a sentence reading substantially as follows:

“Because we have not formed a conclusion as to whether an unfavorable outcome is either probable or remote (as defined in the ABA Statement of Policy), we express no opinion as to the likelihood of an unfavorable outcome or the amount or range of any possible loss to the Company”.

Any response letter containing a Loss Contingency description which does not include a sentence similar to the foregoing must be signed or otherwise approved by [a member of the Firm Response Letter Committee].

The Commentary forming a part of the ABA Statement of Policy observes that “statements that litigation is being defended vigorously and that a client has meritorious defenses do not, and do not purport to, make a statement about the probability of outcome in any measurable sense.”

The information which we provide to auditors regarding Loss Contingencies can have a significant effect on, and is therefore very important to, the client. Depending on the nature of the information, the auditors may, for example, either “qualify” their audit report or insist that the client establish a loss reserve. Should such a situation arise, all Firm attorneys are expected to demonstrate a sincere willingness to cooperate in any way possible so that the needs and wishes of our clients are satisfied. In most situations, it is possible to expand on the description of a Loss Contingency in a way which satisfies the concerns of the auditors but which nonetheless does not result in the rendering of an opinion as to probable outcome or amount of loss.